lill'lii!  .      i^Msti 


THE  LIBRARY 
OF 

THE  UNIVERSITY 

OF  CALIFORNIA 

LOS  ANGELES 

SCHOOL  OF  LAW 
GIFT  OF 

John  Adams 


Digitized  by  the  Internet  Archive 

in  2008  with  funding  from 

IVIicrosoft  Corporation 


http://www.archive.org/details/financingofpubliOOigna 


The  Financing  of 
Public  Service  Corporations 


BY 

MILTON  B.  IGNATIUS,  LL.M. 

Of  the  New  York  Bar 

Assistant  to  General  Valuation  Counsel,  New  York  Central 

Lines;  formerly  Statistician  and  Accountant,  Public  Service 

Commissions  of  New  York 


NEW  YORK 

THE    RONALD    PRESS    COMPANY 
1918 


1^  s^-f 


Copyright,  1918,  by 
The  Ronald  Press  Company 


William  G.  Hewitt  Press.  Brooklyn.  Printers 
J.  F.  Tapley  Co..  New  York.  Binders 


TO     MY    WIFE 

WHOSE  FAITH  IN  THIS,  MY  INITIAL  UNDERTAKING, 

HAS   BEEN   SUCH  AN  AID,  THIS   BOOK  IS 

AFFECTIONATELY   INSCRIBED. 


4ry 


Sf) 


PREFACE 

I  have  written  this  book  as  the  result  of  experience  in 
dealing  with  the  financing  of  public  service  corporations, 
gained ■  through  my  work  with  the  Public  Service  Commis- 
sions of  New  York  State  and  also  in  private  employment. 

It  has  been  my  aim  to  offer  in  this  one  volume  a  compre- 
hensive discussion  of  all  the  important  aspects  of  public  ser- 
vice corporation  financing,  from  the  inception  of  the  enter- 
prise and  the  issue  of  certificates  of  interest  or  indebtedness, 
to  the  expenditure  of  the  proceeds  and  the  permanent  record 
thereof.  I  have  intended  it  for  the  use  of  corporation  officials 
and  employees,  representatives  of  the  public  engaged  in  the 
task  of  regulation,  the  bankers  and  brokers  who  are  a  neces- 
sary part  of  the  financial  organization,  and  in  general  for  that 
part  of  the  public  which  takes  an  active  interest  in  the  affairs 
of  this  most  important  branch  of  industry.  In  order  to  ac- 
complish this  purpose  it  has  been  necessary  at  times  to  dwell 
at  length  upon  elementary  principles  and  at  other  times  to 
forego  detailed  discussion  of  some  complicated  problems.  I 
offer  the  book,  however,  confident  that  these  will  not  be  con- 
sidered as  vital  defects,  since  the  thorough  discussion  of  ele- 
mentary principles  is  absolutely  necessary  to  the  placing  of  a 
proper  foundation.  If  these  principles  are  thoroughly  under- 
stood and  the  possibilities  of  their  application  pointed  out,  the 
most  difficult  problems  may  be  solved  as  they  arise. 

Anyone  who  has  attempted  to  discuss  the  law  of  corpo- 
rate finance  will  realize  how  difficult  it  is  to  avoid,  on  the  one 
hand,  the  tedious  detail  of  constant  reference  to  the  statutes 
of  all  the  states,  and,  on  the  other  hand,  the  inadequacy  of 
any  general  statement.  In  my  present  task  this  difficulty  has 
been  very  much  greater  because  of  the  volume  of  public  ser- 

V 


VI 


PREFACE 


vice  commission  laws  and  decisions  to  be  considered.  In  the 
attempt  to  avoid  this  difficuhy  I  have  very  naturally  limited 
myself  to  the  work  of  the  Commission  with  which  I  have 
been  the  most  familiar — the  Public  Service  Commission  for 
the  Second  District  of  New  York.  There  is,  however,  a 
more  important  reason  for  the  careful  study  of  the  work  of 
this  Commission  and  of  the  laws  under  which  it  operates. 

The  State  of  New  York  adopted  a  policy  of  comprehensive 
regulation  over  public  service  corporations  at  a  very  earlv 
date  under  the  guidance  of  Governor  Charles  E.  Hughes,  who, 
with  high-minded  purpose,  appointed  to  office  a  group  of 
Commissioners  who  brought  to  the  task  a  notable  degree  of 
serious  study,  careful  thought,  and  adequate  comprehension 
of  the  nature  and  importance  of  the  task  upon  which  they 
embarked.  Under  such  conditions  it  was  but  natural  that  this 
Commission,  under  the  direction  of  its  first  Chairman,  Mr. 
Frank  W.  Stevens,  should  at  once  take  its  place  in  the 
foremost  rank  of  regulating  commissions.  I  have  not  at- 
tempted to  present  a  resume  of  the  work  of  this  Commission; 
I  have  thought  it  best  to  quote  freely  from  the  decisions  of 
cases  with  which  I  have  been  personally  familiar,  or  those 
which  were  written  by  the  men  whose  abilities  and  viewpoint 
I  could  personally  gauge.  The  quotations,  however,  have  been 
chosen  with  care  to  avoid  all  peculiarities  of  state  and  local  or 
limited  jurisdiction,  while  at  the  same  time  I  have  tried  to 
make  adequate  reference  to  the  viewpoint  of  other  Commis- 
sions and  to  differences  in  matters  of  jurisdiction,  so  that  the 
value  of  the  book  as  a  general  vv^ork  might  not  be  limited. 
Where  powers  of  the  federal  government  are  involved,  I  have 
referred  to  the  Interstate  Commerce  Commission  as  well. 

I  have  found  it  to  be  generally  true  that  measures  which  are 
too  often  proclaimed  to  be  acts  of  "high  finance"  or  in  abuse  of 
the  correct  principles  of  capitalization  and  assignable  to  im- 
proper motives,  were  often  resorted  to  by  men  who  believed  not 
only  in  the  legality  but  also  in  the  propriety  and  morality  of  their 


PREFACE 


vu 


acts;  instead  of  being  swayed  by  improper  motives,  many  of 
them  were  conscientiously  trying  to  do  their  duty  in  conserving, 
perpetuating,  and  enhancing  the  interests  entrusted  to  their 
care.  True,  they  sometimes  erred  in  faiHng  to  recognize  a 
pubHc  trust  as  well,  but  that  conception  has  been  a  matter  of 
evolution  and  only  recently  did  it  begin  to  be  clearly  defined. 
I  am  sure  that  no  one  reading  these  pages  will  gain  the  im- 
pression that  I  condone  or  defend  these  acts;  I  have  not  hesi- 
tated to  condemn  practices  which  are  now  known  to  be  clearly 
improper,  but  if  at  the  time  of  their  adoption  they  were  gen- 
erally accepted  as  proper,  I  deem  it  a  matter  of  justice  to  set 
forth  the  extenuating  circumstances  so  that  at  least  the  c{ues- 
tion  of  personal  motives  may  not  befog  the  discussions  which 
continuously  arise.  Under  the  driving  pressure  of  an  emer- 
gency we  repeatedly  do  things  which,  viewed  later  in  retro- 
spect and  dissociated  from  the  emergency,  we  may  be  criticized 
for  doing.  Only  those  who  have  actually  engaged  in  financing 
can  adequately  appreciate  the  difficult  position  of  the  one  who 
must  reconcile  with  the  interests  of  his  corporation,  which 
must  have  capital  at  the  lowest  cost,  the  interests  of  the  in- 
vestor who  places  the  highest  price  on  his  assistance,  at  the 
same  time  complying  in  full  with  statutes  which  are  more 
restrictive  than  permissive  in  purpose. 

Misunderstanding  or  incompleteness  of  information  con- 
cerning the  economics,  accounting,  and  other  incidents  of  cor- 
poration finance  continue  to  be  a  source  of  trouble.  In  a  large 
number  of  instances  those  in  charge  of  the  financing  have 
limited  their  work  to  the  banking  and  legal  aspects  of  issuing 
the  necessary  stocks  and  bonds,  and  have  not  studied  with 
equal  care  the  methods  of  accounting  for  the  proceeds  and  of 
recording  other  incidents.  In  consequence,  through  the  ab- 
sence of  correlation,  there  are  presented  ambiguities  which  are 
susceptible  to  adverse  interpretation. 

Not  all  of  the  misunderstanding  has  been  on  the  side  of 
the  corporations,  however;  in  a  needlessly  large  number  of 


Vlll 


PREFACE 


instances  the  devices  which  have  been  condemned  by  the  pub- 
lic were  originally  adopted  because  of  unwise  and  improper 
limitations  which  the  public  itself  had  placed  upon  the  expan- 
sion of  desirable  and  necessary  enterprises.  Then,  again, 
much  of  the  friction  caused  by  the  attempt  to  regulate  capi- 
talization through  public  service  commissions  has  been  due 
simply  to  differences  in  viewpoint — corporation  officials  and 
bankers,  on  the  one  hand,  have  insisted  upon  "practical"  con- 
siderations, while  the  representatives  of  the  public,  engaged 
as  they  were  in  laying  down  a  system  of  control,  had  to  reach 
fundamental  principles  which  to  the  capitalist  seemed  theo- 
retical. There  was,  of  course,  no  basic  conflict  between  the 
two  viewpoints,  and  if  each  side  had  advanced  a  few  steps 
further,  they  would  have  arrived  at  common  ground.  To 
point  the  way  to  this  common  ground  is  the  mission  of  this 
book. 

I  could  wish  for  no  more  opportune  time  than  the  present 
in  which  to  issue  this  book.  We  are  engaged  in  a  war  the 
most  outstanding  feature  of  which  is  its  imperative  demand 
for  the  marshalling  of  all  economic  resources,  the  rectifica- 
tion of  all  false  foundations,  and  the  strengthening  of  all 
insubstantial  structures.  To  many  people  a  book  on  corpora- 
tion finance  will  seem  to  be  far  removed  from  the  necessities 
of  the  present  conflict,  but  is  it  not  in  reality  very  closely 
related  to  it,  dealing,  as  it  does,  with  one  of  its  most  important 
phases  ?  Corporate  financing  has  ceased  to  be  a  purely  private 
affair.  The  transfer  of  railroad  operating  control  to  the  Gov- 
ernment of  the  United  States  was  an  epochal  event;  it  neces- 
sarily brings  in  its  train  a  vast  number  of  problems,  many  of 
which  are  incidents  of  financing.  The  wisdom  of  the  plans 
to  be  adopted,  the  instruments  of  finance  to  be  used,  and  the 
apportionment  of  benefits  and  liabilities  between  the  operators 
and  the  corporation,  are  all  matters  which  must  be  based  on 
thorough  knowledge  of  the  financial  structure  of  these  corpo- 
rations as  they  now  exist,  and  a  full  realization  of  the  circum- 


PREFACE  ix 

stances  controlling,  the  forces  regulating,  and  the  reasons 
explaining,  the  many  incidents  in  the  financial  history  of  these 
enterprises. 

An  extension  of  public  regulation  over  industrial  corpora- 
tions was  apparent  before  the  beginning  of  the  Great  War. 
Such  regulation  is  now  rapidly  expanding  and  it  is  only  natu- 
ral that,  in  the  formulation  of  principles  and  practices  to  con- 
trol the  accounts  and  finances  of  these  classes  of  corporations, 
reliance  should  be  placed  upon  the  precedents  established  in 
the  public  utility  field.  I  have  sought  to  keep  this  situation  in 
mind,  and  while  dealing  primarily  with  public  service  corpora- 
tions I  have  tried  to  serve  those  interested  in  industrial  cor- 
porations as  well. 

I  take  this  opportunity  of  acknowledging  my  debt  of 
gratitude  to  Messrs.  William  C.  Wishart,  Statistician  for  New 
York  Central  Lines;  Henry  C  Hasbrouck,  Chief  of  Division 
of  Statistics  and  Accounts,  New  York  Public  Service  Com- 
mission, Second  District ;  John  Bauer,  Assistant  Professor  of 
Economics,  Princeton  University;  William  P.  Coleman,  Ac- 
countant, New  York  Public  Service  Commission,  First  Dis- 
trict ;  and  to  other  friends  who  by  their  advice  and  suggestion, 
and  through  fidelity  in  the  wearisome  task  of  reviewing  the 
manuscript,  have  made  possible  the  present  character  of  this 
book  and  lent  support  to  the  confidence  with  which  the  author 
sends  it  forth. 

Milton  B.  Ignatius 
New  York  City, 
April  15,  1918 


CONTENTS 


Part  I — Corporations  and  Public  Regulation 
Chapter  Page 

I    Corporations i 

§  I.     Corporations  Defined 

2.  Joint-Stock  Associations 

3.  Joint-Stock  Associations  Defined 

4.  Classification  of  Corporations 

5.  Stock   Corporations 

6.  Corporate  Charters 

7.  Corporate  Powers 

8.  The  Instruments  of  Corporate  Finance 

II    Public  Service  Corporations  and  Commissions    .     .       14 
§    9.     Public  Service  Corporations 

10.  What  Constitutes  Public  Service 

11.  Rule    as    to    Determination    of    Public    Service 

Corporations 

12.  Relationship  Between  Public  Service  Corpora- 

tions and  the  Public 

13.  Regulation  by  Commission 

14.  Public  Service  Commissions 

15.  Federal  Interstate  Commerce  and  Trade  Com- 

missions 

Part  II— Capital  Stocks 

III     Issue  and  Transfer  of  Capital  Stock 31 

§  16.  Capital  and  Capital  Stock 

17.  Authority  for  Issue  of  Capital  Stock 

18.  Par  Value  of  Capital  Stock 

19.  Certificates  of  Stock 

20.  Issue  of  Stock 

21.  Payment  for  Shares  of  Stock 

22.  Subscriptions  to  Capital  Stock 

23.  Transfer  of  Certificates  of  Stock 

24.  Certificates  of  Stock  as  Negotiable  Instruments 

25.  Shares  of  Stock  Taxed  as  Personal  Property 

xi 


xii  CONTENTS 

Chapter  Page 

IV    Relation  of  Par  Value  to  Price  of  Issue  and  Value 

OF  Stock ,       54 

§  26.  Capital  Stock  to  be  Issued  at  Par 

27.  Watered  Stock 

28.  (i)   Stock  Issued  for  Property  or  Services 

29.  (2)  Statutory  Restraints  on  Watering  Stock 

30.  (3)  Effect  of  Watering  Stock  of  Public  Service 

Corporations 

31.  (4)  Aspects  of  Stock-Watering  Sometimes  Con- 

sidered Defensible 

32.  Stock  Issued  at  Discount 

33.  Stock  Issued  at  Premium 

34.  Accounting  for  Issues  of  Stock  at  Discount  or 

Premium 

35.  Par  Value  in  Relation  to  Actual  Value 

36.  Issue  of  Shares  Without  Par  Value 

37.  (i)  New  York   Statute  as   to   Shares   Without 

Par  Value 

38.  (2)  Characteristics   Compared   with   Par  Value 

of  Shares 


V    Stockholders  and  Corporate  Control 

§  39.     Corporate  Control 
40 


Voting  Rights 
Proxies 
Voting  Trusts 
Majority  Control 

Special     Responsibilities     of     Majority     Stock- 
holders 
Minority  Representation 
Qualifications  of  Stockholders 
Stock  of  Corporation  Held  by  Itself 


VI    Classification  of  Capital  Stock 96 

§  48.  Authority  for   Classification 

49.  Common  Stock 

50.  Preferred  Stock 

51.  Preferment  as  to  Assets 

52.  Lien  of  Preferred  Stock 

53.  Preferment  in  Dividends 

54.  (i)  Participating  and  Non-participating 

55.  (2)  Cumulative  and  Non-cumulative 

56.  Preferment  in  Control 


CONTENTS  xiii 

Chapter  Page 

57.  Convertible  Preferred  Stock 

58.  Redeemable  Preferred  Stock 

59.  Special  Classes  of  Stocks 

VII     Dividends 112 

§  60.     Declaration  of  Dividends 

61.  Dividends  Out  of  Surplus  Profits 

62.  Determination  of  Surplus 

63.  (i)   Importance  of  Correct  Accounting 

64.  (2)   Balance     Sheet,     Income     Statement,     and 

Profit  and  Loss  Account 

65.  (3)   Real     Surplus     Distinguished     from     Book 

Surplus 

66.  (4)   Manipulation  of  Surplus 

67.  Amount  of  Surplus  Which  May  Be  Divided 

68.  Dividends  in  Relation  to  Wasting  Assets 

69.  Stockholders'   Title   to,   and    Remedy   for,   Un- 

divided  Profits 

70.  Mediums  of  Distribution 

71.  Cash  Dividends 

72.  Scrip  Dividends 

73.  Bond  Dividends 

74.  Stock  Dividends 

75.  Property  Dividends 

76.  Dates  of  Declaration  and  Payment  of  Dividends 

Part  III— Funded  Debt 

VIII    Bonds,  Trust  Deeds,  and  Mortgages 147 

§  "/"J.  Corporate  Borrowing 

78.  "Loan-Capital" 

79.  Funded  and  Unfunded  Debt 

80.  Corporate  Bond  Issues 

81.  Bonds  and  Notes 

82.  Bonds  and  Stocks 

83.  Par  Value  of  Bonds 

84.  Security  for  Funded  Debt 

85.  Mortgages  and  Deeds  of  Trust 

86.  Parties    to,    and    Authority    for,    Execution    of 

Trust  Deed 

87.  The  Bond  Agreement 

88.  Parties  to  the   Bond  Agreement 

89.  Coupon  and  Registered  Bonds 


XIV 


CONTENTS 


Chapter 


Page 


90.  Property  Subject  to  Mortgage 

91.  Security  Value  of  Property  Mortgaged 

92.  Control,  Actual  and  Contingent,  of  Bondholders 

93.  Trustees 

94.  Certification  of  Bonds  by  Trustee 

95.  Custody  of  Stocks  and  Bonds  Pledged  as  Col- 

lateral 

96.  Enforcement   of   Lien   for   the   Satisfaction    of 

Debt 

97.  Reorganization 


IX    Classification  of  Bonds 

§    98.  Bond  Characteristics 

99.  Mortgage  Bonds  Secured  on  Realty 

100.  Mortgage  Bonds  Secured  on  Personalty 

loi.  Ranking  Order  of  Liens 

102.  Debts  Unsecured  by  Mortgage  or  Pledge 

103.  Reinforced  Security 

104.  Taxation  of  Bonds 


185 


X     Bond  Interest  and  Net  Yield 210 

§  105.  Interest 

106.  Payment  of  Bond  Interest 

107.  Nominal  Interest  Rate 

108.  Efifective  Interest  Rate 

109.  Issue  of  Bonds  at  Discount  or  Premium 
no.  Bond  Values 

111.  Net  Dividend  Yield 

112.  Net  Interest  Yield 

113.  Accounting    for    Premium    and    Discount    on 

Bonds 

114.  Interest  Payable  in  Gold  Coin  or  Legal  Tender 


XI    Maturity,  Refunding,  and  Redemption  of  Bonds 

§115.  Permanency  of  Funded  Debt 

116.  Interminable  and  Extra-Long-Term  Bonds 

117.  Long-Term  Bonds 

118.  Short-Term  Bonds  and  Notes 

119.  Redeemable,  Callable,  and  Optional  Bonds 

120.  Convertible  Bonds 

121.  Redemption  of  Debt  Upon  Maturity 

122.  Amortization  of  Debt 

123.  (i)   Serial   Bonds 


228 


CONTENTS  XV 

Chapter  Page 

124.  (2)  Sinking  Funds 

125.  (3)  Effect  of  Serial  Maturities  or  Sinking  Fund 

Accruals 

126.  (4)  Equalizing  Annual  Burden  of  Amortization 

127.  (s)  Sinking  Fund  Investments 

128.  (6)  Extent  to  Which  Sinking  Funds  Are  Now 

Used 

XII    Relation  of  Bonds  to  Stock 251 

§  129.     Importance    of     Proper    Proportion     Between 
Stocks  and  Bonds 

130.  (i)   Earlier  Tendency  Toward  Greater  Propor- 

tion of  Bonds 

131.  (2)   Earlier  Tendency  Correcting  Itself 

132.  (3)  Stockholders'   Investment   Should   Support 

Loans 

133.  Statutory   Provisions    Regulating   Proportion 

134.  Considerations     Governing     Determination     of 

Proper  Proportion 
135-     (i)   Considerations  of  Corporate  Control 
136.     (2)  Adequacy  and  Apportionment  of  Earnings 
137-     (3)  Relative    Ease    in    Marketing    Stocks    or 

Bonds 


Part  IV — Capitalization 

XIII  Public  Regulation  of  Stock  and  Bond  Issues     .     .     267 

§  138.  Demand  for  Regulation 

139.  Direct  and  Indirect  Regulation  of  Capitalization 

140.  Federal  Regulation  of  Capitalization 

141.  State  Regulation  of  Capitalization 

142.  Limitations  of  State  Jurisdiction 

143-     (0  Jurisdiction  Over  Stock  and  Bond  Issues  of 

Domestic  Corporations 
144.     (2)  Jurisdiction  Over  Stock  and  Bond  Issues  of 

Foreign  Corporations 

XIV  The  Task  of  Public  Service  Commissions  in  Regu- 

lating Capitalization 286 

§  145.     Statutory    Purposes    for    Which    Capitalization 
May  Be  Authorized 
146.     Scope  of  Commission's  Authority 


XVI 


CONTENTS 


Chapter 


Page 


147 
148 

I49> 

150, 
151 

152 
153 

154 

155 
156 


(i)  Application  of  the  Statute 

(2)  Incidents   of   Capitalization   to   Be   Consid- 
ered by  Commission 

(3)  Limitations  upon  Discretionary  Powers  of 
Commission 

Problem   of  Existing   Overcapitalization 
(i)   Extent  to  Which   Regulation   May  Be  Re- 
troactive 

(2)  Nature  of  Overcapitalization 

(3)  Regulation      of      Accounts      a      Corrective 
Measure 

(4)  Overcapitalization    Need    Not    Bar    Proper 
Stock  and  Bond  Issues 

Financial  Record  and  Status  of  Applicant  to  Be 

Considered 
Paramount  Duty  of  Commission 


XV     Collateral  Aspects  of  Regulating  Stock  and  Bond 

Issues 308 

§  157.     Control  Over  New  Enterprises 
158.     (i)  Duplication  of  Plants  to  Be  Avoided 
159'     (2)   Basis     of    Right     for     Protection     Against 
Competition 

160.  (3)   Loss     of     Right     for     Protection     Against 

Competition 

161.  (4)  Requisites   for  Authorization   of   New   En- 

terprises 

162.  Regulation  of  Rates 

163.  Regulation  of  Operations 

164.  Requirements  of      Public      Policy — (i)  Safe- 

guarding Investments 

165.  (2)   Conserving   Integrity   of   Credit 

166.  (3)   Promoting  the   Public  Interest 


XVI     Fixed  and  Floating  Capital  and  the  Accounting 

Therefor 335 

0  167.  Fixed  and  Floating  Capital 

168.  Basis  of  Fixed  Capital  Accounts 

169.  Necessary  Detail  for  Fixed  Capital  Accounts 

170.  Additions  and  Betterments  Accounts 

171.  Accounting  for  Fixed  Capital  Withdrawn 

172.  Maintenance  and  Depreciation  of  Fixed  Capital 


CONTENTS 


XVI I 


Chapter 


Page 


173.  (i)   Relative    Importance   of    Maintenance    Ex- 

pense Accounts 

174.  (2)  Depreciation  Accounts 

175.  (3)  Method  of  Recording  Depreciation 

176.  (4)  Over-  or  Under-Statement  of  Maintenance 

to  Be  Avoided 

177.  Accounting  for  Replacements  of   Capital 


XVII     Issue  of  Stocks  and  Bonds  for  Acquisition  of  Fixed 
Capital 

§  178.     Fixed  Capital  Classified 

179.  Capitalization     for     Acquisition     of     Intangible 

Capital 

180.  (i)  Organization  Expenses 

181.  (2)  Franchises 

182.  (3)  Patent  Rights 

183.  (4)   Contract  Rights 

184.  (5)   Other  Intangible  Capital 

185.  Capitalization  for  Acquisition  of  Tangible  Capi- 

tal— (i)   Construction 

186.  (2)   Construction  Under  Contract 

187.  (3)   Purchase  of  Plant 

188.  Capitalization     for     Acquisition     of     Working 

Capital 


358 


XVIII     Intercorporate    Relationships,    Investments,    Con- 
solidations, Mergers,  and  Reorganizations  . 

§  189.     Intercorporate  Relationships  Defined 

190.  The   Development  of  Intercorporate   Relation- 

ships 

191.  Possible  Dangers  in  Intercorporate  Holdings 

192.  Capitalization    for    Purposes   of   Intercorporate 

Holdings 

193.  (i)   Relationship  Which  Should  Exist  Betv^een 

Projects  of  Affiliated  Companies 

194.  (2)    Value   of   Stocks   and    Bonds   Acquired    to 

Support  Those  Issued 
195-     (3)   Company     Acquiring     Holdings     Not     to 
Burden  Its  Own  Operations 

196.  Holding  Companies 

197.  Stocks,  Bonds,  or  Physical  Properties  Acquired 

as  Investments 

198.  Consolidations   and   Mergers 


394 


xviii  CONTENTS 

Chapter  Page 

199.  (i)  Capitalization  of  Consolidating  Companies 

Important 

200.  (2)  When   Values  of  Consolidating  Properties 

Need  to  Be  Considered 

201.  (3)   Considerations  of  Public   Policy 

202.  Corporate  Reorganizations 

XIX     Capitalization  for  Sundry  Purposes 426 

§  203.     Reimbursement     of     Moneys     Expended    from 
Income 

204.  (i)  Capitalization  for  This  Purpose  a  Limited 

Right 

205.  (2)   Effect    of    Reimbursing    Income    by    Stock 

Issue 

206.  (3)  Analysis  of  Accounts  to  Determine  Amount 

to  Be  Reimbursed 

207.  (4)  Appraisals    to    Supplement    or    Check    Ac- 

counting Analyses 

208.  (5)  Reimbursement  of  Proper   Expenditures   a 

Matter  of  Right 

209.  Capitalization   for   Investment   or    Maintenance 

of  Service 

210.  Capitalization  for  the  Discharge  or  Refunding 

of  Obligations — (i)   Funding  Operations 

211.  (2)   Refunding  Operations 

212.  The     Need     for     Constructive    Regulation     of 

Finance 


The  Financing  of 
Public   Service   Corporations 

Part    I — Corporations   and   Public    Regulation 


CHAPTER    I 

CORPORATIONS 

§  I.     Corporations  Defined 

A  corporation  is  an  association  of  persons  who  have  united 
themselves  or  their  capital  for  the  performance  of  a  definite 
purpose,  and  who,  as  such  association,  have  secured  from  the 
sovereign  authority  of  the  jurisdiction  in  which  the  association 
is  domiciled,  a  franchise  to  exercise  certain  powers  beyond 
those  comprehended  within  their  natural  rights  as  individuals. 
Chief  of  these  powers  is  that  of  perpetual  existence  of  the 
corporation,  independent  of  the  continued  association  of  the 
persons  wlio  brought  about  its  organization.  Thus,  the  cor- 
poration becomes  an  independent  entity,  a  thing,  as  it  were, 
with  a  life  of  its  own,  vested  with  powers  which  it  alone  may 
exercise,  and  enjoying  privileges  not  available  to  natural  per- 
sons or  partnerships. 

Since  it  is  in  the  exercise  of  these  various  privileges  and 
rights  that  corporations  most  often  appear  in  courts  of  law, 
there  has  arisen  the  legal  definition,  framed  by  Chief  Justice 
Marshall  in  the  Dartmouth  College  Case,  that  "a  corporation 
is  an  artificial  being,  invisible,  intangible,  and  existing  only  in 
contemplation  of  law."  ^ 

The  legal  definition  relates  more  directly  to  the  status  of 


^  Dartmouth  College  v.  Woodward,  4  Wheat.     518  (636). 

I 


2  CORPORATIONS   AND   PUBLIC    REGULATION 

the  corporation  in  theory  of  law  than  to  its  organic  nature; 
it  personifies  the  corporation  for  the  purpose  of  acting  upon  it 
and  subjecting  it  to  legal  duties,  or  enabling  it  to  exercise  legal 
rights.  The  definition,  therefore,  considers  the  corporation 
as  a  complete  entity  and  regards  the  individual  members  as 
mere  component  parts  of  the  whole;  for  the  purpose  of  legal 
action  the  emphasis  is  upon  the  corporate  entity  and  the  per- 
sonal membership  is  made  incidental.  On  the  other  hand,  the 
definition  given  in  the  first  paragraph  is  concerned  with  the 
organic  nature  of  the  corporation;  it  looks  upon  the  corpora- 
tion as  a  collection  of  individuals  who  have  become  vested 
with  special  powers  and  privileges  according  to  the  authority 
of  the  law;  it  lays  emphasis  upon  the  association  of  persons 
and  makes  the  corporate  form  incidental  to  the  accomplish- 
ment of  the  association's  purposes. 

The  legal  definition  has  been  quoted  too  often  without  due 
reference  to  the  human  elements  of  the  corporation,  so  that 
we  have  in  common  use  such  expressions  as  "fiction  of  law," 
"creature  of  statute,"  etc. — characterizations  which  are  proper 
enough  for  legal  purposes  and,  so  far  as  they  relate  to  the 
form  of  the  corporation,  properly  reflect  its  existence  not  as  a 
natural  fact  but  in  an  assumed  and  artificial  form  created  by 
the  law;  they  fail  utterly,  however,  to  indicate  that  the  cor- 
porate enterprise  is  a  personal  enterprise,  that  its  acts  are 
those  of  persons  just  like  ourselves,  that  its  profits  accrue  to 
the  persons  who  have  become  associated  in  the  enterprise  and 
who  depend  upon  those  profits  for  their  income,  and  that  if 
no  profit  accrues  theirs  is  the  loss.  That  definition  will  be  the 
most  correct,  and  the  most  useful,  which  lays  emphasis  first 
upon  the  body,  i.e.,  the  association  of  natural  persons,  and 
second  upon  the  cloak,  i.e.,  the  impersonal  form  through  which 
those  persons,  under  proper  sanction  of  law,  conduct  their 
operations. 

It  is  important  to  remember  that  the  corporation  comes 
into  existence  by  sanction  of  law  extended  to  the  incorporators 


CORPORATIONS  3 

who  thereby  become  authorized  to  associate  themselves  under 
the  corporate  form.  This  right  is  perpetuated  in  the  members 
of  the  corporation,  no  matter  how  their  numbers  or  identity 
may  change.  Hence,  the  right  to  be  a  corporation  is  a  fran- 
chise of  the  members  of  a  corporation  and  not  of  the  cor- 
poration itself.-  Over  this  franchise  the  latter  has  no  control; 
it  may  sell  all  other  franchises  and  every  bit  of  property  or 
every  claim  that  it  possesses,  but  it  cannot  convey  or  assign 
the  right  to  be  a  corporation.  Neither  can  the  members  who 
own  that  right  sell  or  transfer  it  except  in  the  precise  manner 
provided  by  the  laws  of  the  state  from  which  the  right  was 
derived.  They  may  surrender  the  right  by  dissolving  the  cor- 
poration; or  it  may  be  taken  away  from  them  because  of  their 
default  in  the  performance  of  prescribed  acts,  or  the  commis- 
sion of  a  fraudulent  or  prohibited  act ;  they  may  also  assign 
and  transfer  the  right  to  another  corporation  through  merger 
or  consolidation  efifected  in  the  manner  prescribed  by  statute. 
The  association  of  a  number  of  persons  is  essential  to  the 
organization  of  a  corporation.  An  individual  cannot  incor- 
porate; neither  can  one  corporation  become  a  direct  party  to 
the  incorporation  of  another  corporation. 

§  2.    Joint-Stock  Associations 

The  term  "joint-stock  association"  is  used  with  different 
meanings.  The  best  understood  meaning  is  that  illustrated  in 
the  organization  of  the  earliest  companies  which,  because  of 
the  magnitude  of  the  undertakings  upon  which  they  entered, 
had  to  operate  under  a  form  which  would  nullify  the  limitations 
of  ordinary  partnerships  and  also  avoid  the  almost  prohibitive 
difficulties  involved  in  obtaining  a  charter  from  the  Crown. 
Originally  the  only  corporations  known  to  English  law  were 
associations  organized  pursuant  to  charters  granted  by  the 
sovereign.     History  has  recorded  the  enterprises  of  the  Mer- 


*  For  a  discussion  of  the  differences  between  "general"  franchises  and  "special" 
franchises,  see  §  i8i. 


4  CORPORATIONS   AND    PUBLIC    REGULATION 

chant  Adventurers  of  England,  chartered  by  Richard  II,  in 
1390;  of  the  Russia  Company,  chartered  by  Queen  Mary  in 
1554;  of  the  East  India  Company,  chartered  by  Queen  Eliza- 
beth in  1600;  of  the  Hudson  Bay  Company,  the  Turkey  Com- 
pany, etc.  The  beginnings  of  the  joint-stock  principle  are 
illustrated  in  the  transactions  of  the  East  India  Company, 
which  during  its  earlier  years  used  to  form  a  "joint  stock" 
for  each  voyage,  made  up  of  the  contributions  of  groups  of 
members  who  thereafter  shared  pro  rata  in  the  profits  of  that 
individual  enterprise. 

As  these  chartered  companies  increased  in  size  and  im- 
portance, Parliament  began  to  claim  regulatory  authority  over 
them  and  before  long  was  granting  charters  of  a  similar 
nature.  Along  with  this  development  came  the  organization 
of  joint-stock  associations  under  the  common  law.  In  sub- 
stance these  were  simply  large  partnerships  which  used  the 
device  of  transferable  shares;  the  only  differences  in  form 
were  those  necessitated  by  the  size  of  the  organization  and 
the  special  machinery  required  to  unify  the  control  of  the 
many  members.  Joint-stock  companies  were  quite  numerous 
at  the  end  of  the  seventeenth  century  and  the  beginning  of  the 
eighteenth ;  they  seem  to  have  become  almost  as  popular  as 
some  of  the  modern  "trusts."  The  Bubble  Act  of  17 19,  taking 
its  name  from  the  speculative  enterprise  of  the  South  Sea 
Company  and  enacted  after  the  bursting  of  the  "bubble"  had 
caused  a  disastrous  panic,  declared  these  companies  to  be  com- 
mon nuisances  and  indictable  as  such.  They  continued  to 
flourish,  however,  in  spite  of  the  Act,  which  was  extended 
over  the  American  colonies  in  1741  and  was  eventually  re- 
pealed in  1825.  In  the  meantime  incorporation  by  special 
parliamentary  bills  had  come  into  general  use. 

§  3.     Joint-Stock  Associations  Defined 

A  joint-stock  association  has  been  defined  as  "an  associa- 
tion of  persons  for  the  purpose  of  business,  having  a  capital 


CORPORATIONS  c 

stock  divided  into  shares,  and  governed  by  articles  of  associa- 
tion which  prescribe  its  objects,  organization,  and  procedure, 
and  the  rights  and  HabiHties  of  the  members,  except  that  the 
articles  cannot  release  the  members  from  their  liability  as 
partners  to  the  creditors  of  the  company."  ^ 

This  is  the  definition  of  a  joint-stock  association  organized 
under  the  common  law,  and  is  to  be  distinguished  from  one  or- 
ganized and  empowered  by  statute,  as  in  England  and  New 
York  State.  The  latter  has  a  joint-stock  associations  law  which 
includes  the  definition:  "The  term  'joint-stock  association' 
includes  every  unincorporated  joint-stock  association,  com- 
pany or  enterprise  having  written  articles  of  association  and 
capital  stock  divided  into  shares,  but  does  not  include  a  cor- 
poration; and  the  term  'stockholder'  includes  every  member  of 
such  an  association." 

"The  distinction  between  joint-stock  companies  and  cor- 
porations and  the  essential  characteristics  of  each  are  not 
clearly  defined,"  is  the  opinion  of  one  commentator,*  referring 
to  this  definition;  while  a  decision  of  the  Court  of  Appeals  in- 
cludes the  statement  that  in  New  York  "joint-stock  companies 
have  all  the  attributes  of  a  corporation  except  the  right  to 
have  and  use  a  common  seal."  ^  The  substantial  difTerence  be- 
tween them  is  in  the  matter  of  liability.  The  members  of 
joint-stock  associations  do  not  enjoy  the  privilege  of  limited 
liability  which  is  common  to  stockholders  of  corporations. 

Familiarity  with  the  nature  of  joint-stock  associations  is 
very  helpful  in  arriving  at  an  adequate  understanding  of  the 
nature,  organization,  and  privileges  of  the  modern  corpora- 
tions of  which  they  were  the  forerunners.  Some  of  the  large 
express  companies  now  operating  are  joint-stock  associations. 
In  reports  of  the  Public  Service  Commission,  Second  District, 
New  York,  the  Adams  Express  Company  is  described  as  a 
"joint-stock  association  formed  by  voluntary  agreement  under 

'  Cook  on  Corporations,  Seventh  Edition,  Vol.  2,  page  1463. 

*  White  on  Corporations,  page  1086. 

^  People  ex  re!.  Piatt  v.  Wemple,  117  N.  Y.  136;  see  also  Hibbs  v.  Brown,  190  N.  Y.  16;. 


6  CORPORATIONS  AND   PUBLIC   REGULATION 

the  common  law  of  the  State  of  New  York";  the  American 
Express  Company  "is  not  a  corporation,  but  a  voluntary  part- 
nership or  association  of  persons  organized  under  articles  of 
agreement  between  its  members  under  the  common  law  of  the 
State  of  New  York";  and  the  National  Express  Company  is 
"an  unincorporated  association  organized  under  the  common 
law  of  the  State  of  New  York  ....  with  a  nominal  capital 
of  $500,000."  In  the  tabulated  balance  sheets  the  entries 
against  the  item  of  capital  stock  are  explained  by  a  note  that 
the  "Respondent  is  an  unincorporated  joint-stock  association, 
but  for  convenience  reports  on  the  liabilities  side  of  the  balance 
sheet  at  a  nominal  par  value  the  shares  representing  the  bene- 
ficial interest  of  its  members." 

§  4.     Classification  of  Corporations 

Corporations  are  broadly  divided  into  two  classes — public 
and  private. 

Public  corporations  are  governmental  institutions,  e.g., 
cities  and  incorporated  villages,  which  are  political  subdivisions 
for  the  administration  of  the  public  affairs  of  the  community. 

Private  corporations  may  be  classified  into  a  number  of 
groups,  each  differing  from  the  other  in  form,  in  kind  or 
degree  of  powers  to  be  exercised,  or  else  in  general  purpose. 
A  classification  as  to  general  purpose  may  be  as  follows: 

1.  Ecclesiastical  corporations 

2.  Eleemosynary  corporations 

3.  Civil  corporations 

A  simpler  and  more  convenient  classification  is  that  con- 
tained in  the  General  Corporation  Law  of  New  York  which 
may  be  said  to  group  corporations  according  to  form.  "A 
corporation  shall  be  either 

1.  A  municipal  corporation 

2.  A  stock  corporation,  or 

3.  A  non-stock  corporation" 


CORPORATIONS  7 

Municipal  corporations  come  within  the  general  class  of 
public  corporations,  leaving  private  corporations  classified  into 
stock  and  non-stock  corporations.  Non-stock  corporations  are 
also  called  membership  corporations;  they  are  those  not  or- 
ganized for  private  gain,  and  include  both  the  first  and  second 
groups  of  the  classification  first  made,  i.e.,  ecclesiastical  and 
eleemosynary  corporations.  These  represent  associations  of 
persons  who  have  united  themselves  primarily,  and  their 
capital  only  incidentally  or  not  at  all,  for  the  performance  of 
a  definite  purpose.  Hundreds  of  political  organizations,  for 
instance,  are  incorporated  every  year  to  support  the  candidacy 
of  one  nominee  or  of  another,  and  their  membership  contains 
large  numbers  of  persons  who  have  simply  pledged  themselves 
to  the  cause. 

Stock  corporations  come  within  the  classification  of  civil  ^ 
corporations  and  are  those  organized  for  private  gain;  they 
represent  associations  of  persons  who  have  united  their  capital 
primarily,  and  themselves  only  incidentally,  for  the  perform- 
ance of  a  certain  purpose.  It  is  true  that  in  many  instances 
the  members  have  not  only  contributed  their  capital  but  are 
also  devoting  all  of  their  knowledge,  time,  and  skill  to  the 
business  of  the  corporation,  but  in  these  instances  the  mem- 
bers who  perform  such  service  have  been  elected  as  officers  or 
engaged  as  employees  of  the  corporation. 

Corporation  finance  deals  only  with  the  affairs  of  stock 
corporations.  It  will  be  well  worth  while,  therefore,  to  give  a 
comprehensive  definition  of  stock  corporations  by  way  of 
introduction. 

§  5.     Stock  Corporations 

A  stock  corporation  is  an  organization  of  persons  who 
have  united  their  capital  in  an  enterprise  for  the  purpose  of 
deriving  a  profit  therefrom,  and  who,  by  contracting  each  with 
the  other  and  all  collectively  with  the  state,  have  had  their 


«  "To  facilitate  the  conduct  of  business,"  Standard  Dictionary. 


8  CORPORATIONS   AND   PUBLIC    REGULATION 

organization  endowed  with  corporate  existence  for  a  specified 
period  of  years  or  in  perpetuity,  and  with  other  specific  or 
incidental  powers  to  be  exercised  in  the  corporate  conduct  of 
the  enterprise.  The  contribution  of  each  member  to  the  capital 
of  the  corporation  measures  the  proportion,  subject  to  quali- 
fication by  agreement  between  the  members,  of  his  share  in  the 
control,  capital,  and  profits  of  the  corporation ;  it  also  measures 
the  extent  of  his  financial  responsibility  in  the  corporate  enter- 
prise and  limits  his  liability  for  the  corporate  debts. 

If  a  statutory  definition  is  preferred,  reference  may  again 
be  made  to  the  New  York  law  which  defines  a  stock  corpora- 
tion as  "a  corporation  having  a  capital  stock  divided  into 
shares,  and  which  is  authorized  by  law  to  distribute  to  the 
holders  thereof  dividends  or  shares  of  the  surplus  profits  of 
the  corporation.  A  corporation  is  not  a  stock  corporation  be- 
cause of  having  issued  certificates  called  certificates  of  stock, 
but  which  are  in  fact  merely  certificates  of  membership,  and 
which  is  not  authorized  by  law  to  distribute  to  its  members 
any  dividends  or  share  of  profits  arising  from  the  operations 
of  the  corporation." 

The  privilege  of  limited  liability  is  undoubtedly  the  most 
noteworthy  attribute  of  a  stock  corporation.  The  individual 
owners  of  a  business  and  those  associated  in  general  partner- 
ship take  upon  themselves  personally  full  liability  for  all  debts 
incurred  in  the  business ;  but  those  who  are  associated  as  pro- 
prietors of  an  incorporated  business  are  not  charged  with  per- 
sonal responsibility  for  any  of  the  corporate  debts  beyond  the 
amount  of  their  agreed  contributions  to  the  stock  of  the  cor- 
poration, except  that  under  certain  circumstances  they  become 
liable  for  amounts  due  to  employees  as  wages. 

§  6.     Corporate  Charters 

A  corporation  becomes  incorporated  when  it  receives  from 
the  sovereign  authority  legal  sanction  to  exercise  corporate 
rights.     The  grant  of  that  sanction  necessarily  involves  the 


CORPORATIONS  o 

acceptance  of  the  purposes  of  the  association,  which  must 
accord  with  public  pohcy;  hence,  an  association  whose  objects 
are  opposed  to  pubHc  pohcy  and  interest,  or  which  are  im- 
moral or  illegal,  cannot  be  incorporated.  The  mere  fact  that 
incorporation  has  been  effected  in  form  will  not  estop  the 
grantor  from  later  c|uestioning  the  propriety  of  the  objects  and 
nullifying  the  corporate  privileges  if  necessary. 

1.  Federal  Incorporation.  In  the  United  States,  sov- 
ereign authority  is  vested  in  the  individual  states,  and  these 
states  have  delegated  certain  sovereign  powers  to  the  Congress 
of  the  United  States.  Congress,  therefore,  does  not  possess 
authority  to  incorporate  or  charter  private  corporations  (out- 
side of  the  District  of  Columbia)  except  as  it  has  received 
delegated  authority  from  the  states.  Under  its  constitutional 
power  of  controlling  currency.  Congress  has  chartered  national 
banks ;  it  can  exercise  like  power  as  to  interstate  carriers  and 
other  corporations  engaged  in  commerce,  under  its  constitu- 
tional power  to  regulate  interstate  commerce  or  to  establish 
post-roads  and  post-offices.  It  has  twice  chartered  railroad 
corporations  under  the  authority  of  its  control  over  post- 
roads  ;  the  first  one  was  the  Union  Pacific  Railroad,  chartered 
July  I,  1862,  and  the  other  the  Northern  Pacific  Railroad, 
chartered  July  2,  1864.  Congress  has,  however,  frequently 
been  urged  to  enact  general  incorporation  laws,  either  requir- 
ing interstate  carriers  to  incorporate  thereunder  so  as  to  derive 
all  their  powers  from  the  federal  government  and  be  re- 
sponsible to  it,  or  giving  them  the  option  of  a  federal  or  state 
charter.  Some  such  legislation  will  undoubtedly  be  enacted 
before  long  in  the  logical  extension  of  the  jurisdiction  now 
exercised  by  the  federal  government  over  rates,  operations, 
accounts,  etc.,  of  interstate  carriers  under  the  constitutional 
authority  to  regulate  interstate  commerce. 

2.  State  Incorporation  by  Special  Act  or  General  Law. 
Incorporation  was  at  first  effected  by  the  direct  and  specific 
action  of  the  sovereign  authority;  for  instance,  the  charter 


lO         CORPORATIONS   AND    PUBLIC    REGULATION 

from  the  Crown  or  Parliament,  and  after  the  independence  of 
the  American  Colonies,  from  the  legislatures  of  the  individual 
states.  For  more  than  half  a  century  in  this  country  incor- 
poration by  special  act  of  the  state  legislatures  was  the  only 
method  in  use ;  the  corporation  was  created  by  the  enactment 
of  a  special  statute  which  named  the  incorporators  and  or- 
ganized them  into  "a  body  corporate  and  politic";  it  then 
enumerated  the  powers,  defined  the  privileges  and  duties,  and 
became  the  charter  of  the  corporation — the  authority  for  its 
existence  and  activities. 

The  method  was  satisfactory  as  long  as  the  number  of 
associations  seeking  incorporation  was  limited ;  but  the  num- 
ber of  these  increased  yearly  until  at  last  the  enactment  of  the 
many  statutes  required  became  too  great  a  burden  for  the 
legislatures.  In  order  to  dispose  of  them  all,  the  work  of 
introducing  and  passing  special  acts  was  at  times  necessarily 
perfunctory  and  indiscriminate.  It  was  but  natural  that  under 
such  conditions  abuses  of  the  privilege  should  creep  in,  sug- 
gesting to  many  people  the  existence  of  legislative  corruption; 
moreover,  the  corporate  form  had  become  so  important  a 
device  in  the  development  of  commercial  and  industrial  enter- 
prises that  its  free  and  unrestricted  use  was  generally  ad- 
vocated. All  of  these  considerations  required  the  introduction 
of  a  more  expeditious  and  general  method  of  incorporation; 
so,  instead  of  enacting  a  separate  and  special  statute  for  each 
corporation,  legislatures  enacted  general  statutes  which  pre- 
scribed the  conditions  under  which,  and  the  purposes  for 
which,  incorporation  might  be  had;  also  providing  the  ma- 
chinery to  register  compliance  with  the  conditions  and  the 
extension  of  the  authority  of  the  state  for  the  creation  of  the 
corporation.  The  enactment  of  such  general  incorporation 
laws  was  universal  in  this  country,  and  all  states  now  provide 
for  the  organization  of  corporations  under  general  laws. 

The  New  York  Constitution  contains  a  provision,  inserted 
in  1846,  reading  as  follows: 


CORPORATIONS  II 

"Corporations  may  be  formed  under  general  laws;  but 
shall  not  be  created  by  special  act,  except  for  municipal  pur- 
poses, and  in  cases  where  in  the  judgment  of  the  legislature 
the  object  of  the  corporation  cannot  be  attained  under  general 
laws.  All  general  and  special  acts  passed  pursuant  to  this 
section  may  be  altered  from  time  to  time  or  repealed." 

Incorporation  under  general  laws  is  now  effected  by  filing 
with  the  proper  state  officials  a  certificate  prepared  by  the  in- 
corporators in  statutory  form  and  manner.  In  New  York 
the  certificate  must  be  filed  with  the  Secretary  of  State  and 
with  the  clerk  of  the  county  wherein  the  office  of  the  corpora- 
tion is  to  be  located.  These  are  the  usual  requirements  of 
most  states.  The  filing  is  the  act  of  incorporation  and  the 
date  thereof  is  the  date  of  incorporation.  The  charter  of  a 
corporation  so  organized  consists  of  the  statute  and  the  cer- 
tificate of  incorporation.  The  latter,  by  setting  forth  the 
facts  concerning  organization  and  incorporation,  and  describ- 
ing the  powers  to  be  exercised,  links  up  the  statute  with  that 
one  corporation;  thus,  in  place  of  general  provisions  applicable 
to  many  corporations,  it  substitutes  by  appropriation  a  set  of 
specific  provisions  applicable  to  and  controlling  the  single 
corporation  thereby  created. 

§  7.     Corporate  Powers 

Those  things  which  the  corporation  is  legally  authorized 
to  do  are  its  powers,  and  these  may  be  express  or  implied. 
Express  powers  are  those  specifically  described  and  enumer- 
ated in  the  charter,  whether  that  be  a  special  legislative  act  or 
a  general  act  operating  upon  the  corporation  through  the 
latter's  certificate  of  incorporation.  Implied  powers  are  those 
which  the  corporation  must  exercise  as  a  natural  incident  of 
conducting  the  business  or  doing  the  things  which  it  has  been 
expressly  authorized  to  do.  The  implied  powers  are  enumer- 
ated as  follows : 

'To  buy,  hold,  and  sell  necessary  real  estate  and  other 


12         CORPORATIONS   AND    PUBLIC    REGULATION 

property  in  its  corporate  name;  to  sue  and  be  sued  in  that 
name ;  to  do  business  in  its  corporate  name  without  rendering 
its  stockholders  Hable  as  partners  for  its  debts;  to  govern  its 
officers,  agents,  and  business  by  by-laws;  to  issue  transferable 
certificates  of  stock  to  its  stockholders;  to  have  its  business 
managed  by  directors  instead  of  by  the  stockholders  as  in  a 
partnership;  to  continue  business  although  its  stockholders 
die  or  sell  their  stock ;  to  borrow  money  and  give  bills,  notes, 
and  acceptances;  to  issue  negotiable  bonds;  to  assign  for  the 
benefit  of  creditors;  and,  except  in  qiiasi-puhlic  corporations, 
such  as  railroads,  to  give  a  mortgage." 


M  7 


§  8.     The  Instruments  of  Corporate  Finance 

Two  things  are  essential  to  the  inception  and  maintenance 
of  every  business  enterprise — capital  and  skill.  When  business 
enterprises  were  conducted  in  small  units,  both  of  these  essen- 
tials were  furnished  by  the  one  person  who  owned  and  con- 
ducted the  business;  his  was  all  the  risk,  and  his  all  the  profits, 
representing  both  compensation  for  labor  and  return  upon 
capital.  Just  a  step  farther,  two  or  more  persons  united  in 
partnership,  furnished  the  capital,  and  divided  the  conduct  of 
the  business  between  themselves,  sharing  in  the  risk  and 
profits.  As  business  increased  to  larger  proportions,  even  the 
ordinary  partnership  proved  inadequate,  for  business  de- 
manded the  capital  of  those  whose  active  participation  in  the 
management  of  the  enterprise  was  not  desired  and  was  im- 
practicable because  of  their  number.  Thus  there  was  de- 
veloped the  joint-stock  and  later  the  incorporated  association, 
their  growth  keeping  pace  with  the  development  of  wealth  and 
credit  facilities.  First  they  attracted  the  capital  of  those  who 
would  share  the  risk  and  the  profits — these  were  investors  in 
proprietorship;  then  they  had  to  attract  the  capital  of  those 
who  were  not  willing  to  invest  in  proprietorship  but  who 
would  lend  their  money  for  use  in  the  enterprise  but  not  sub- 


'  Cook  on  Corporations,  Seventh  Edition,  Vol.  I,  page  ii. 


CORPORATIONS  13 

ject  to  the  risk  thereof — investors  in  credits.  Hence  the 
present  task  of  corporate  finance,  which  is  that  of  bringing  to- 
gether the  resources  of  the  capitaHst  and  the  skill  of  the  op- 
erator, and  of  so  dissociating  the  incidents  of  ownership  and 
allocating  the  net  income  as  to  pay  interest  to  the  investor  in 
credits,  compensate  the  operator,  and  divide  the  profits  among 
the  investors  in  proprietorship. 

The  instruments  of  corporate  finance  consist  of  shares  of 
stock,  representing  interests  of  proprietors,  and  bonds  or  other 
certificates  of  indebtedness,  representing  claims  of  creditors. 
This  is  a  very  general  classification,  and  each  group  includes 
many  subclasses  which  will  be  noted  hereinafter. 


CHAPTER    II 

PUBLIC  SERVICE  CORPORATIONS  AND 
COMMISSIONS 

§  9.     Public  Service  Corporations 

"Private"  corporations  have  been  already  distinguished 
from  "public"  corporations  in  a  general  classification.  In  re- 
cent years  the  term  "private"  corporation,  as  ordinarily 
used,  has  come  to  have  a  somewhat  different  meaning  through 
the  introduction  of  another  term,  "public  service"  or  "public 
utility"  corporation,  the  latter  referring  to  a  corporation  whose 
business  enterprise  is  subject  to  such  a  degree  of  public  inter- 
est as  to  give  it  distinctive  status. 

It  is  necessary  to  emphasize  that  the  distinction  is  largely 
a  question  of  the  relative  degrees  of  public  interest.  Many 
attempts  have  been  made  to  find  the  basis  of  distinction  in  the 
enterprise  itself,  but  without  success.  Much  of  the  difficulty 
may  perhaps  be  obviated  if  it  is  understood  that  the  char- 
acterization of  "public  service  corporation"  indicates  not  so 
much  the  inherent  nature  of  the  undertaking  as  it  does  the 
nature  of  the  relationship  between  the  corporation  and  the 
public.  A  corporation  considered  today  to  be  engaged  in  a 
purely  private  undertaking  may  tomorrow  be  considered  as 
engaging  in  a  public  service  undertaking;  the  undertaking  it- 
self remains  the  same,  but  some  change  in  the  condition  of 
the  community  modifies  the  relationship  theretofore  existing. 
The  relationship  itself,  however,  is  governed  by  well-defined 
principles. 

Ever  since  commerce  became  a  well-defined  part  of  the 
social  structure,  certain  enterprises  have  been  considered  to 
partake  of  the  nature  of  a  public  calling,  and  those  who  en- 

14 


PUBLIC   SERVICE   CORPORATIONS 


15 


gage  in  them  are  held  to  be  under  special  and  extraordinary 
obligations  to  the  public ;  for  instance,  they  are  under  the  duty 
of  serving  all  comers  alike,  while  the  owner  of  a  private  enter- 
prise can  serve  or  refuse  to  serve  whomsoever  he  pleases.  The 
development  of  the  law  of  public  service  corporations  consti- 
tutes one  of  the  most  interesting  chapters  in  the  history  of  our 
economic  progress.  The  transition  from  the  small  individual 
enterprises  of  the  period  when  the  law  of  carriers  and  similar 
companies  first  began  to  be  formulated,  to  the  large  corporate 
enterprises  of  today,  has  been  very  great  indeed ;  equally  great 
has  been  the  development  of  the  law  from  the  first  definition 
of  special  duties  to  the  present  voluminous  body  of  law,  both 
common  and  statutory,  relating  to  public  service  corporations. 

§  10.     What  Constitutes  Public  Service 

What  are  the  distinguishing  or  significant  characteristics 
of  the  public  service  corporation  ?  Upon  what  circumstances 
does  the  existence  of  its  peculiar  relationship  to  the  community 
depend?  What  tests  can  be  applied  to  determine  whether  it  is 
engaged  in  a  private  or  a  public  service  undertaking? 

Common  Carriers.  "A  common  or  public  carrier  is  one 
who  undertakes  as  a  business,  for  hire  or  reward,  to  carry 
from  one  place  to  another  the  goods  of  all  persons  who  may 
apply  for  such  carriage,  provided  the  goods  be  of  the  kind 
which  he  professes  to  carry,  and  the  person  so  applying  will 
agree  to  have  them  carried  upon  the  lawful  terms  prescribed 
by  the  carrier ;  and  who,  if  he  refuses  to  carry  such  goods  for 
those  who  are  willing  to  comply  with  his  terms,  becomes  liable 
to  an  action  by  the  aggrieved  party  for  such  refusal. 

"To  bring  a  person,  therefore,  within  the  description  of  a 
common  carrier  the  following  characteristics  must  appear: 

I.  He  must  be  engaged  in  the  business  of  carrying  goods 
for  others  as  a  public  employment,  and  must  hold  himself  out 
as  ready  to  engage  in  the  transportation  of  goods  for  persons 
generally  as  a  business,  and  not  as  a  casual  occupation. 


l6         CORPORATIONS   AND    PUBLIC    REGULATION 

2.  He  must  undertake  to  carry  goods  of  the  kind  to  which 
his  husiness  is  confined. 

3.  He  must  undertake  to  carry  by  the  methods  by  which 
his  business  is  conducted  and  over  his  estabhshed  road. 

4.  The  transportation  must  be  for  hire. 

5.  An  action  must  He  against  him,  if  he  refuses  without 
sufficient  reason  to  carry  such  goods  for  those  who  are  wilHng 
to  comply  with  his  terms.  And  this  duty  or  ol^hgation  to  the 
pubHc  by  reason  of  the  public  nature  of  the  employment  and 
the  increased  responsibility  imposed  upon  him  by  the  law  upon 
the  grounds  of  public  policy,  mainly  distinguish  the  common 
from  the  mere  private  carrier  for  hire."  ^ 

The  above  is  one  of  the  best  definitions  available;  at  the 
same  time  it  is  an  excellent  example  of  the  inadequacy  of  the 
definitions  on  this  subject.  Notice  that  among  the  inherent 
qualities  which  distinguish  the  common  carrier  from  other 
corporations  is  included  the  fact  that  "an  action  must  lie 
against  him"  for  refusal  to  serve  as  a  common  carrier.  Mani- 
festly, that  such  an  action  will  lie  must  depend  upon  a  prior 
determination  that  the  party  proceeded  against  is  a  common 
carrier.  The  definition  of  the  nature  of  the  undertaking  is 
mixed  with  the  description  of  the  status  ascribed  to  the  cor- 
poration engaged  in  that  undertaking;  whereas,  there  is  no 
difficulty  in  establishing  the  status  of  the  corporation  after  it  is 
once  established  that  it  is  engaged  in  a  public  service  under- 
taking. Confusions  such  as  this  are  to  be  found  in  most  of 
the  general  definitions  usually  relied  upon  and  it  is  difficult, 
therefore,  to  formulate  a  comprehensive  rule. 

Other  Public  Service  Corporations.  Common  carriage  as 
a  test  of  a  public  caUing  is  applicable,  obviously,  to  carriers 
alone.  It  is  a  test  and  nothing  more ;  for  other  classes  of  per- 
sons or  corporations  engaged  in  a  public  calling  or  service 
there  will  be  found  other  and  equally  satisfactory  tests.    These 


1  Hutchinson  on  Carriers,  Third  Ed.,  Vol.  I,  sections  47-48,  pages  41-42-     Quotations 
rearranged  in  paragraphs  for  convenience  here. 


PUBLIC    SERVICE   CORPORATIONS 


17 


tests  are  valuable,  but  a  clear-cut  definition  of  what  shall  be 
deemed  to  constitute  a  public  undertaking,  uniformly  appli- 
cable to  all  kinds  and  classes  of  public  service,  would  be  of 
immeasurably  greater  worth.  Public  service  corporations,  so 
called  either  because  of  the  principles  of  the  common  law  or 
because  of  statutory  designation,  in  addition  to  including  all 
the  common  carriers,^  from  the  earliest  types  to  the  latest — 
from  stage  coaches  to  jitneys,  with  all  the  other  modes  of 
common  transportation  in  between,  e.g.,  horse-cars,  steam 
railways,  cable  roads,  electric  roads,  steamships,  etc. — together 
with  those  who  furnish  collateral  carrier  service,  e.g.,  express 
companies,  sleeping  car  companies,  etc.,  also  include  many  other 
kinds  of  businesses,  such  as  the  operation  of  telephone  and  tele- 
graph systems;  the  generation,  transmission,  and  distributioh 
of  electricity,  gas,  and  steam;  the  storage  and  distribution  of 
water  for  general  or  irrigation  purposes.  Sewer  companies, 
toll  bridge  companies,  warehousemen  and  elevatormen,  wharf- 
ingers, etc.,  are  in  the  list. 

The  Massachusetts  Public  Service  Commission  has  ruled 
that  companies  furnishing  stock  ticker  service  are  public  utili- 
ties, while  the  New  Jersey  Commission  exercises  jurisdiction 
over  ice  companies  and  the  Oklahoma  Public  Service  Commis- 
sion over  cotton-gins.  What  inherent  quality  or  qualities  do 
these  undertakings  possess  in  common  with  each  other  so  that 
they  can  all  be  grouped  under  the  one  general  head  of  public 
service  undertakings?  These  have  been  said  to  be  enterprises 
in  which  the  community  itself — municipality,  state,  or  na- 
tion— could  properly  engage  without  running  counter  to  the 
theory  of  governmental  functions.  But  what  domain  of  in- 
dustry or  commerce  have  not  governments  gone  into?  They 
have  not  been  limited  to  the  operation  of  railroads,  or  water 
distribution  systems,  of  telephone  and  telegraph  lines,  of  light- 
ing plants,  and  similar  services.  The  activities  of  municipalities 


2  There  is  a  tendency  to  distinguish  between  pubhc  service  corporations  and  com- 
mon carriers.  The  term  "public  service  corporation"  is  used  throughout  this  book  to 
include  common  carriers  as  well,  unless  a  distinction  is  clearly  indicated. 


l8         CORPORATIONS   AND    PUBLIC    REGULATION 

have  at  times  included  the  manufacture  and  sale  of  commodi- 
ties. No  one  has  yet  prescribed  a  rule  which  will  distinguish 
between  those  operations  which  are  within  the  legitimate  ac- 
tivities of  governmental  agencies  and  those  which  must  be  left 
to  private  enterprise. 

The  Constitution  of  the  State  of  California  provides: 
"Every  private  corporation,  and  every  individual  or  association 
of  individuals  owning,  operating,  managing,  or  controlling  any 
commercial  railroad  ....  is  hereby  declared  to  be  a  public 
utility  subject  to  such  control  and  regulation  by  the  Railroad 
Commission  as  may  be  provided  by  the  legislature,  and  every 
class  of  private  corporations,  individuals,  or  associations  of  in- 
dividuals hereinafter  declared  by  the  legislature  to  be  public 
utilities  shall  likewise  be  subject  to  such  control  and  regu- 
lation." ^ 

Relation  to  Needs  of  Community.  It  is  well  to  note  that 
under  the  above  law  the  legislature  may  declare  certain  cor- 
porations to  be  engaged  in  public  service  undertakings  which 
theretofore  had  been  thought  to  be  conducting  purely  private 
enterprises.  The  new  status  of  any  one  corporation  will  rest 
upon  legislative  declaration,  i.e.,  the  statement  of  a  finding  as 
to  existing  facts.  The  business  has  not  changed,  it  remains 
just  the  same  as  before;  the  status  of  the  corporation-  is 
changed,  for  it  becomes  "subject  to  such  control  and  regula- 
tion by  the  Railroad  Commission  as  may  be  provided  by  the 
legislature."  Obviously,  the  business  itself  is  not  the  subject 
matter  of  the  declaration  but  rather  the  relation  of  that  busi- 
ness to  the  needs,  condition,  and  circumstances  of  the  com- 
munity wherein  it  is  conducted. 

If  this  statement  is  true,  then  it  becomes  easy  to  under- 
stand why  cotton-gins,  for  example,  may  be  called  public  utili- 
ties in  communities  where  they  represent  an  essential  part  of 
the  industrial  and  social  life  of  the  people.  The  conditions 
surrounding   many   other   enterprises   heretofore   considered 


'  Article  12,  Section  2^.     Italics  used  here  are  not  found  in  original. 


PUBLIC    SERVICE   CORPORATIONS  iq 

purely  private  in  nature  may  in  time  change  so  as  to  bring 
them  within  the  category  of  pubHc  service  undertakings. 

In  a  leading  case  involving  the  question  of  a  public  under- 
taking, the  United  States  Supreme  Court  repeated  the  rule  of 
the  common  law  as  follows: 

"We  find  that  when  private  property  is  'affected  with  a 
public  interest,  it  ceases  to  be  juris  privati  only.'  This  was 
said  by  Lord  Chief  Justice  Hale  more  than  two  hundred  years 
ago  in  his  treatise,  De  Portuhis  Maris,  i  Harg.  Law  Tracts, 
78,  and  has  been  accepted  without  objection  as  an  essential 
element  in  the  law  of  property  ever  since.  Property  does  be- 
come clothed  with  a  public  interest  when  used  in  a  manner  to 
make  it  of  public  consequence,  and  affect  the  community  at 
large.  When,  therefore,  one  devotes  his  property  to  a  use  in 
which  the  public  has  an  interest,  he,  in  effect,  grants  to  the 
public  an  interest  in  that  use,  and  must  submit  to  be  controlled 
by  the  public  for  the  common  good,  to  the  extent  of  the  in- 
terest he  has  thus  created.  He  may  withdraw  his  grant  by 
discontinuing  the  use ;  but,  so  long  as  he  maintains  the  use,  he 
must  submit  to  the  control."  * 

§  II.  Rule  as  to  Determination  of  Public  Service  Corpora- 
tions 
Summed  up,  the  general  rule  may  be  stated  as  follows: 
Any  manufacturing,  trading,  transporting,  or  other  business 
undertaking  which  produces  a  commodity  or  renders  a  service 
essential  to  the  economic  and  social  welfare  of  the  community 
in  which  it  operates,  so  that  the  constant  availability  of  its 
commodities  or  service  in  satisfactory  mode,  quality,  and  re- 
lation to  public  demand  must  be  assured,  and  where  the  pro- 
duction or  rendition  of  the  commodity  or  service  is  or  ought 
to  be  under  unified  and  exclusive  control  within  that  com- 
munity, will  be  deemed  to  be  a  public  service  undertaking. 
Consequently,  the  corporation  engaged  therein  may,  at  such 

*  Munn  V.  People,  94  U.  S.  113  d^). 


20         CORPORATIONS   AND    PUBLIC    REGULATION 

times  as  public  policy  will  warrant  and  demand,  be  declared  to 
be  a  public  service  corporation,  subject  to  the  special  duties 
and  responsibilities  contemplated  by  that  relationship. 

The  necessity  for  unified  and  exclusive  control  of  produc- 
tion indicates  that  the  undertaking  is  a  natural  monopoly. 
Artificial  monopoly  which  may  be  corrected  should  not  be 
brought  within  this  description.  Some  measure  of  necessarily 
monopolized  supply  is  essential  to  charge  the  undertaking  with 
a  compelling  public  interest.  If  the  would-be  purchaser  may 
choose  between  a  number  of  vendors  and  is  under  no  com- 
pulsion to  go  to  any  special  one,  it  is  difficult  to  charge  the 
business  of  those  vendors  with  a  compelling  public  interest,  for 
here  competition  is  an  effectively  regulating  force.  There 
may,  of  course,  be  differences  in  the  extent  of  the  public 
interest  with  which  different  undertakings  may  be  chargeable; 
the  greater  the  interest,  the  more  surely  will  the  undertaking 
become  an  integral  part  of  the  life  of  the  community.  People 
fix  their  residences  and  establish  their  factories,  offices,  and 
stores  according  to  available  transportation  facilities,  water 
supply,  gas,  electricity,  etc. ;  they  direct  their  business  and 
social  relationships  by  means  of  the  telegraph  and  telephone, 
so  that  all  of  these  agencies  become  as  the  arteries  of  a  living 
organism.  Hence,  having  been  once  established  and  projected 
into  the  life  of  the  community,  these  agencies  must  be  main- 
tained; they  cannot  be  withdrawn  at  the  will  of  the  owners 
and  operators  without  the  concurrence  of  the  public.  The 
necessity  for  the  continuance  of  the  service,  if  it  is  of  a  public 
nature,  becomes  compelling  and  imposes  upon  both  the  owners 
of  the  undertaking  and  the  public  that  is  served  mutual  and 
reciprocal  duties. 

§  12.     Relationship  Between  Public  Service  Corporations  and 
the  Public 
It  is  not  necessary  to  go  into  any  lengthy  discussion  of 
the  legal  status  of  public  service  corporations  and  of  the  special 


PUBLIC    SERVICE   CORPORATIONS  21 

duties  to  which  they  are  subjected.  Having  determined  what 
a  public  undertaking  is,  however,  it  is  wortli  while  to  inquire 
briefly  concerning  the  relationship  between  the  public  and  the 
corporation  engaged  in  that  undertaking,  for  there  has  been 
much  misstatement  on  the  subject.  Some  describe  the  cor- 
poration as  a  trustee  in  charge  of  a  public  trust;  others  regard 
it  as  an  agent  for  the  community.  In  both  cases  the  funda- 
mental assumption  is  that  since  the  undertaking,  is  one  in 
which  the  public,  through  its  organized  governmental  units, 
could  itself  engage,  the  present  control  of  that  undertaking  by 
a  private  corporation  is  merely  by  sufferance  and  subject  to  a 
constructive  agreement  to  operate  as  agent  or  trustee.  The 
logic  is  faulty,  for  the  fact  that  the  government  could  or  could 
not  engage  in  a  similar  enterprise  has  nothing  to  do  with  it. 
The  proponents,  however,  find  some  support  in  the  termi- 
nology of  decisions  and  treatises.  The  following  definitions 
are  quoted  over  and  over  again: 

"A  railroad  is  a  public  highway,  and  none  the  less  so  be- 
cause constructed  and  maintained  through  the  agency  of  a 
corporation  deriving  its  existence  and  powers  from  the  state. 
Such  a  corporation  was  created  for  public  purposes.  It  per- 
forms a  function  of  the  state."  ^ 

"It  is  not  the  water  or  the  distributing  works  which  the 
company  may  be  said  to  own,  and  the  value  of  which  is  to  be 
ascertained.  They  were  acquired  and  contributed  for  the 
use  of  the  public;  the  public  may  be  said  to  be  the  real  ozuner, 
and  the  company  only  the  agent  of  the  public  to  administer 
their  use."  ® 

Some  theorists  extend  the  relationship  to  that  of  partners, 
and  in  support  of  their  contention  emphasize  the  grant  of 
franchises  and  public  rights.  The  fundamental  defect  in  this 
as  well  as  the  other  theories  is  that  the  relationship  of  either 
agent  or  partner  involves  duties  and  responsibilities  on  the  part 

"Smyth  V.  Ames    169  U.  S.  466  (5441).     Italics  are  not  to  be  found  in  original. 
«  San   Diego   Water   Co.   v.    San   Diego,   ii8  Calif.   556   (570).      Italics  are  not  to  be 
found  in  original. 


22  CORPORATIONS   AND   PUBLIC    REGULATION 

of  the  public  which  the  latter  has  not  always  been  willing  to 
assume,  such  as  securing  the  investment  in  these  enterprises 
and  guaranteeing  a  return  thereupon  by  protecting  the  cor- 
poration from  undue  competition,  using  its  influence  to  pro- 
cure adequate  rates  for  the  service  rendered,  etc.  The  tend- 
ency of  regulation  by  commission  has  been  to  recognize  these 
compensating  duties,  but  the  introduction  into  legislatures  of 
special  bills  overruling  the  decisions  of  commissions,  the  enact- 
ment of  arbitrary  rate  schedules  into  law,  the  readiness  to 
legislate  as  to  expenses,  and  the  absolute  refusal  to  pass  any 
laws  affording  direct  relief,  evidence  the  apparent  unwilling- 
ness of  the  public  to  accept  the  obligations  in  full.  It  is  fair 
to  say,  however,  that  the  real  attitude  of  the  public  has  not 
yet  been  correctly  expressed.  Hitherto  there  has  been  too 
great  confusion  because  of  direct  charges  of  stock-watering 
and  corporate  wrongdoing,  and  countercharges  of  unfairness, 
of  strike-bills,  and  of  legislative  or  municipal  hold-ups,  so 
that  both  sides  have  resorted  to  means  the  employment  of 
which  was,  to  say  the  least,  inexpedient.  The  matter  is  one 
that  should  be  considered  without  animus  or  prejudice. 

It  does  not  seem  necessary  to  introduce  either  the  rules  of 
agency  or  partnership.  The  definition  of  a  public  service  as 
given  above  indicates  clearly  that  when  a  public  interest  at- 
taches so  as  to  impose  special  duties  upon  the  public  service 
corporation,  compensating  duties  are  contemporaneously  im- 
posed upon  the  public  as  well,  and  both  parties  may  thereafter 
proceed  on  the  assumption  that  these  direct  or  compensating 
obligations  will  be  fully  carried  out.  The  nature  of  the  duties 
to  which  the  corporation  is  subject  is  clearly  understood;  the 
compensating  duties  of  the  public  have  not  been  so  often 
brought  into  question  and  they  have  escaped  the  emphasis  of 
frequent  reiteration.  The  grant  of  franchises  and  the  ex- 
tension of  other  necessary  aids  in  the  establishment  and  main- 
tenance of  the  undertaking  are  the  main  incidents  of  the  public 
responsibility. 


PUBLIC    SERVICE   CORPORATIONS 


23 


§  13.     Regulation  by  Commission 

Regulation  by  commission  may  be  said  to  be  a  general  term 
describing  the  effort,  now  a  mutual  one  between  the  corpora- 
tions and  the  public,  to  formulate  a  satisfactory  and  working 
basis  for  the  thorough  understanding  of  each  other's  rights 
and  the  reciprocal  performance  of  their  duties  and  obligations. 
The  principles  of  regulation  are  of  long  standing,  and,  al- 
though its  methods  appear  to  be  new,  the  innovations  are  no 
more  than  those  which  were  required  by  reason  of  the  vast 
number  of  public  utilities,  their  increasing  variety,  and  the 
expansion  of  individual  undertakings. 

Any  review  of  the  development  of  corporation  regulation 
as  it  now  exists  must  necessarily  deal  largely  with  the  regula- 
tion of  railroad  corporations  and  other  common  carriers, 
since  during  many  years  these  comprised  the  principal  group 
of  public  service  corporations  subjected  to  regulation.  The 
legislation  for  those  classes  of  corporations  has  shaped  the 
later  legislation  for  all  classes  of  public  service  corporations. 
The  more  recent  movement  for  the  regulation  of  other  classes 
of  corporations  is  bound  to  follow  very  closely  the  principles 
and  methods  established  in  the  field  of  public  utilities. 

There  was  a  distinct  advantage  in  incorporating  public 
service  corporations  by  special  act  of  the  legislature.  The  in- 
troduction of  these  bills  gave  valuable  opportunity  for  dis- 
cussion of  the  merits  of  the  proposed  enterprise  and  afforded 
interested  parties  the  privilege  of  a  hearing.  Thus  the  neces- 
sity or  desirability  of  each  proposed  railroad,  for  instance, 
was  passed  upon  by  the  legislature  itself,  and  the  legislation 
could  be  shaped  so  as  to  protect  the  public  interest.  Early 
railroad  charters  contained  many  unusual  provisions  as  to 
operation,  while  the  inclusion  of  schedules  of  rates  was  quite 
common. 

The  change  from  the  system  of  incorporation  by  special 
act  to  that  of  incorporation  under  general  laws  has  already 
been  described.     The  development  of  railroad  regulation  in 


24 


CORPORATIONS   AND    PUBLIC   REGULATION 


New  York  from  that  time  on  is  both  interesting  and  instruc- 
tive. 

Abuses  Under  the  1850  Law.  Incorporation  under  gen- 
eral laws  did  not  at  first  carry  with  it  the  right  of  condemna- 
tion, which  was  a  power  still  jealously  guarded  by  the  legis- 
lature and  which  could  be  exercised  only  upon  specific  author- 
ization of  the  legislature.  Some  measure  of  control  over  the 
launching  of  new  railroad  enterprises  thus  remained  with  the 
legislature,  but  even  that  was  relinquished  in  1850  by  the  en- 
actment of  a  general  railroad  law  under  which  railroad  cor- 
porations were  given  outright  and  without  restriction  the 
power  of  condemning  the  property  necessary  for  their  pur- 
poses. The  complete  abandonment  of  every  vestige  of  regu- 
latory control  over  the  entrance  of  new  corporations  into  a 
field  already  occupied,  or  over  their  construction  and  opera- 
tion, proved  very  unsatisfactory.  A  small  number  of  persons 
could,  simply  by  filing  a  certificate,  organize  a  railway  cor- 
poration with  full  power  to  take  property  by  condemnation 
and  to  build  a  road  wherever  and  in  whatever  manner  they 
saw  fit,  and  to  operate  it  as  they  pleased. 

It  was  no  wonder  that  such  privileges  were  abused;  im- 
proper practices  crept  into  the  organization  and  management 
of  railroads  under  this  system  of  unrestrained  incorporation 
and  free  competition — abuses  which  were  financially  and 
economically  disastrous  in  many  instances,  which  brought  rate 
wars,  and  forced  resort  to  unscrupulous  business  methods  in 
the  struggle  for  existence;  it  was  apparent  that  very  often 
the  power  to  condemn  property  was  being  used  by  so-called 
railroad  corporations,  lacking  both  capital  and  ability  to  en- 
gage in  operation,  to  block  legitimate  construction  and  to 
compel  the  purchase,  at  exorbitant  prices,  of  the  rights  which 
they  had  acquired  under  such  false  pretenses. 

The  results  of  ensuing  rate  wars  and  of  competition  which 
exhausted  the  resources  of  both  competitors  soon  began  to 
produce  a  change  in  the   politico-economic  attitude   toward 


PUBLIC    SERVICE   CORPORATIONS 


25 


these  corporations  whose  naturally  monopolistic  nature  was 
gradually  recognized.  The  necessity  of  state  governments 
reacquiring  the  regulatory  control  which  they  had  so  lightly 
surrendered  then  became  imperative,  and  first  steps  toward 
that  end  were  taken  by  the  creation  of  regulatory  boards. 

The  First  Nezu  York  Conunission  Law.  In  New  York 
State  an  organized  movement  for  the  creation  of  a  Board  of 
Railroad  Commissioners  was  commenced  in  1879,  and  re- 
sulted in  the  creation  of  such  a  commission  in  1882,  the  Board 
of  Railroad  Commissioners  taking  office  January  i,  1883. 
Some  other  states  had  already  taken  this  step  and  others  soon 
followed,  for  it  was  a  popular  movement.  Very  little  power 
and  authority  were  given  to  these  boards  in  the  beginning, 
but  through  succeeding  years  their  powers  and  functions  were 
expanded,  especially  in  regard  to  the  construction  of  new 
roads,  changes  in  rates,  and  fluctuations  in  the  quality  of 
service.  Enforced  publicity  of  financial  practices  and  results 
of  operations  were  among  the  latest  extensions  of  their 
functions. 

§  14.     Public  Service  Commissions 

The  state  supervision  and  regulation  thus  instituted  first 
over  railroads  has  been  extended  during  the  last  quarter  of 
a  century,  reaching  a  high  efficiency  in  the  public  service,  or 
public  utility,  commission  laws  in  many  states,  notably  those 
of  New  York,  Massachusetts,  Wisconsin,  and  California. 
The  jurisdiction  of  these  commissions  covers  practically  all 
classes  of  public  service  corporations;  there  are  some  com- 
paratively unimportant  differences  in  the  classification  con- 
tained in  the  laws  of  the  various  states,  but  these  are  of  local 
interest  and  need  not  be  enumerated  here. 

In  some  states  these  commissions  act  under  constitutional 
authority,  while  in  others  they  have  been  created  solely  by 
legislative  enactment.  In  either  case,  they  represent  the 
agency  by  which  the  state  exercises  direct  regulatory  authority 


26  CORPORATIONS   AND    PUBLIC    REGULATION 

over  the  corporations  which  it  creates,  and  they  also  ad- 
minister certain  measures  of  regulatory  authority  over  cor- 
porations not  created  by  that  state,  but  whose  operations  and 
activities  therein  bring  them  within  state  jurisdiction  in  some 
respects.  It  is  necessary  to  keep  in  mind  that  control  exer- 
cised over  a  corporation  itself  under  the  general  authority  of 
the  state  and  independently  of  jurisdiction  over  the  corpora- 
tion's business,  is  a  different  situation  from  that  of  control 
exercised  over  the  business  and  activities  of  the  corporation 
primarily  and  over  the  corporation  itself  only  incidentally  or 
collaterally.  The  first  rests  upon  the  general  sovereign  author- 
ity of  the  state;  the  latter  upon  the  more  limited  authority  of 
police  power. 

The  powers  of  the  Public  Service  Commissions^  of  New 
York  may  be  said  to  be  typical  of  the  extent  of  supervision  and 
regulation  exercised  by  all  commissions  working  under  a 
policy  of  comprehensive  regulation.  Briefly  summarized,  the 
powers  and  duties  prescribed  by  the  New  York  statute  as  re- 
lating to  the  corporations  placed  within  the  jurisdiction  of 
each  commission  are  as  follows: 

Nezv  Enterprises.  Before  a  corporation  may  build  a  new 
railroad  or  extend  one  into  new  territory,  it  must  receive  from 
the  Commission  a  certificate  of  public  convenience  and  neces- 
sity as  to  the  proposed  construction;  similarly,  corporations 
organized  to  conduct  other  public  utility  enterprises  may  not 
enter  upon  the  construction  of  their  plants  or  exercise  any 
right  or  privilege  under  a  franchise  without  first  obtaining 
the  proper  consent  of  the  Commission. 

No  corporation  may  sell  or  transfer  any  part  of  its  plant 
or  franchises  to  another  corporation  without  the  consent  of 
the  Commission. 

Intercorporate  Relationships.  No  corporation  may  lease 
its  franchises  or  property,  or  make  any  contract  or  agreement 

'  The  plural  is  here  used  because  there  are  two  Commissions  in  New  York,  one  for 
the  First  District,  taking  in  the  territory  of  New  York  City,  and  the  other  for  the  Sec- 
ond District,  taking  in  the  remainder  of  the  State. 


PUBLIC    SERVICE    CORPORATIONS  27 

in  relation  to  the  ownership  or  operation  thereof  without  the 
authorization  of  the  Commission. 

The  acquisition  by  one  pubhc  service  corporation  of  the 
stock  of  any  other  similar  corporation  must  have  the  author- 
ity of  the  Commission. 

Operation.  The  Commission  may,  upon  its  own  motion 
or  upon  a  complaint  before  it,  investigate  operating  conditions 
and  appliances,  order  proper  regulations  and  rules  to  be 
adopted,  or  require  necessary  changes  and  repairs  of  plant 
or  equipment  to  be  made.  It  may  fix  standards  for  measure- 
ment of  purity  or  illuminating  power  of  gas,  and  "prescribe 
from  time  to  time  the  efficiency  of  the  electric  supply  system 
of  the  current  supplied,  and  of  the  lamps  furnished." 

Rates  and  Charges.  Upon  its  own  motion  or  upon  a  com- 
plaint, the  Commission  may  ^  make  investigation  and  determine 
what  shall  constitute  just  and  reasonable  rates  and  charges. 

Capitalisation.  No  stocks,  bonds,  or  certificates  of  in- 
debtedness maturing  in  more  than  one  year,  may  be  issued  by 
any  corporation  without  the  authorization  of  the  Commission, 
which  must  also  prescribe  the  conditions  of  issue  and  sale,  and 
direct  the  disposition  of  the  proceeds. 

Accounts.  The  Commission  may  establish  uniform  sys- 
tems of  accounts  and  forms  of  records  and  memoranda.  It 
has  full  power  to  examine  the  books  and  accounts,  either  in 
cases  where  they  are  brought  directly  into  question,  or  for  the 
purposes  of  its  own  information.  It  may  eVen  direct  specific- 
ally the  accounting  entries  to  be  made  in  recording  an  in- 
dividual transaction. 

Reports.  Annual  reports  are  to  be  furnished  to  the  Com- 
mission, which  may  also  call  for  any  other  regular  or  special 
reports,  or  for  specific  information  upon  particular  points. 
Reports  rendered  to  the  Commission  are  made  public  records, 
and  abstracts  thereof  are  required  to  be  published. 


8  If  the  complaint  is  properly  made,  the  Commission  must,  of  course,  make  the  re- 
quired investigation. 


28         CORPORATIONS   AND    PUBLIC    REGULATION 

Reorganisations.     Reorganizations  are  subject  to  the  su- 
pervision and  control  of  the  Commission. 


The  powers  delegated  to  public  service  commissions,  and 
the  general  purpose  which  they  are  intended  to  accomplish, 
have  been  summarized  very  well  by  the  Public  Utilities  Com- 
mission for  the  District  of  Columbia: 

"The  spirit  and  letter  of  the  Public  Utilities  Law  charge 
the  Commission  with  ascertaining  and  keeping  itself  informed 
as  to  the  manner  and  method  in  which  the  business  of  every 
public  utility  is  conducted.  It  is  charged  with  supervision  and 
regulation  of  the  utility's  organization,  franchises,  property, 
finances,  accounting,  rates,  operation,  and  its  compliance  with 
every  law  applicable  to  it,  including  the  provisions  of  its  own 
charter.  It  is  armed  with  ample  inquisitorial  powers  to  ob- 
tain information  in  any  detail."  ^ 

§  15.  Federal  Interstate  Commerce  and  Trade  Commissions 
Power  to  regulate  commerce  between  the  states  is  dele- 
gated by  the  states  to  the  Congress  of  the  United  States,  and 
under  this  authority  the  federal  government  has  embarked 
upon  a  very  comprehensive  program  of  regulating  interstate 
commerce  corporations.  Here,  of  course,  jurisdiction  is 
acquired  first  over  the  business  in  which  a  corporation  is  en- 
gaged, and  it  is  then  extended  to  control  over  the  corporation 
itself.  While  the  delegation  of  authority  over  interstate  com- 
merce is  broad  enough  to  make  federal  jurisdiction  exclusive 
if  and  when  exercised,  the  extension  of  that  authority  over  the 
corporation  engaged  in  that  interstate  commerce  does  not  be- 
come similarly  exclusive  against  the  state  which  created  it. 

The  constitutional  authority  (Article  I,  Section  8)  is  as 
follows : 

"The  Congress  shall  have  power:    3.    To  regulate  com- 


»  In  re  Washington  Railway  and  Electric  Co.,  P.  U.  R.  1915— F-  34  (41)- 


PUBLIC    SERVICE   CORPORATIONS 


29 


merce  with  foreign  nations,  and  among  the  several  states,  and 
with  the  Indian  tribes." 

There  is  a  related  section  which  may  some  time  be  taken 
advantage  of  to  provide  a  method  of  vesting  in  the  federal 
government  exclusive  jurisdiction  over  certain  classes  of  cor- 
porations. The  method  must  necessarily  be  that  of  federal  in- 
corporation. This  "post-roads"  section  of  the  Constitution  is 
as  follows: 

"The  Congress  shall  have  powder:  7.  To  establish  post- 
ofiEices  and  post-roads." 

Exercising  its  powers  under  the  commerce  clause,  Con- 
gress in  1887  created  the  Interstate  Commerce  Commission, 
and  since  then  has  been  constantly  granting  it  more  and  more 
authority.  This  has  been  supported  by  judicial  decisions 
which  have  reflected  the  growing  sentiment  for  unification  of 
control.  The  powers  of  this  Commission  are  very  similar  to 
those  enumerated  above  for  the  Public  Service  Commissions  of 
New  York,  keeping  in  mind  the  limitation  to  interstate  com- 
merce, and  omitting  jurisdiction  over  corporate  organization, 
reorganization,  or  capitalization.  Definitions  of  intercorporate 
relationships  are  not  embodied  in  the  Interstate  Commerce 
Commission  Act  itself,  but  specifically  provided  for  in  the 
Clayton  Act  which  was  an  attempt  at  correlating  anti-trust 
.laws  and  judicial  interpretations. 

Extending  Its  jurisdiction  to  include  corporations  not 
brought  within  the  Interstate  Commerce  Commission  Act,  a 
Federal  Trade  Commission  was  created  by  Congress  on  Sep- 
tember 26,  19 14,  and  certain  additional  powers  were  also  con- 
ferred upon  it  by  the  Clayton  Act,  approved  October  15,  1914- 
The  Trade  Commission  organized  March  16,  191 5,  merging 
into  Itself  the  Bureau  of  Corporations.  The  Commission's 
report  for  the  year  ended  June  30,  1916,  summarized  its  pow- 
ers as  follows  (page  14) : 

All  of  the  powers  which  the  Commission  is  empowered  by 
the  Trade  Commission  act  to  investigate  or  determine,  in- 


30         CORPORATIONS   AND   PUBLIC    REGULATION 

volve  questions  of  fact  and  require  work  which  is  partly,  and 
often  wholly,  of  an  economic  character,  namely : 

1.  To  investigate  the  organization,  business,  conduct, 

etc.,  of  corporations.*''     (Sec.  6,  par.  a.) 

2.  To  require  annual   and   special  reports   from  cor- 

porations.   (Sec.  6,  par.  b.) 

3.  To  investigate  and  make  recommendations  concern- 

ing the  observance  of  decrees  in  anti-trust  cases. 
(Sec.  6,  par.  c.) 

4.  To  investigate  alleged  violations  of  anti-trust  laws. 

(Sec.  6,  par.  d.) 

5.  To  recommend  adjustments  of  corporations  alleged 

to  be  violating  anti-trust  acts.     (Sec.  6,  par.  e.) 

6.  To  investigate  trade  conditions  in  and  with  foreign 

countries,  particularly  with  respect  to  combina- 
tions.    (Sec.  6,  par.  h.) 

7.  To  recommend  appropriate  form  of  decree  in  anti- 

trust cases.     (Sec.  7.) 

8.  To  determine  and  prevent  unfair  methods  of  com- 

petition.    (Sec.  5.) 
The  same  is  true  of  those  provisions  of  the  Clayton  Act, 
the  enforcement  of  which  is  entrusted  to  the  Commission. 
These  provisions  relate  to 

9.  Price  discriminations.  (Sec.  2.) 
ID.  Tying  contracts.     (Sec.  3.) 

11.  Intercorporate  stockholding.     (Sec.  7.) 

12.  Interlocking  directorates.     (Sec.  8.) 

Broadly  speaking,  the  economic  work  under  these  powers 
may  be  grouped  as  follows : 

1.  Compilation  of  information  of  a  general  character 

through  corporation  reports. 

2.  Specific    investigations   of   particular   corporations, 

industries,  or  business  problems,  including  those 
relating  to  the  enforcement  of  the  anti-trust  laws. 

3.  Investigation    of    cases    arising    under    the    quasi- 

judicial,  or  administrative  powers  of  the  Com- 
mission under  section  5  of  the  Trade  Commission 
Act,  and  Sections  2,  3,  7,  and  8  of  the  Clayton 
Act. 


^o  Except  banks  and  companies  within  jurisdiction  of  Interstate  Commerce  Commis- 
sion. 


Part  II— Capital  Stocks 


CHAPTER    III 

ISSUE    AND    TRANSFER    OF    CAPITAL    STOCK 

§  1 6.     Capital  and  Capital  Stock 

The  primary  purpose  in  organizing  a  stock  corporation  is 
to  accumulate  in  one  sum  and  apply  to  one  enterprise  the  capi- 
tal of  many  persons.  All  the  special  features  of  corporate  or- 
ganizations, e.g.,  limited  liability  of  members,  control  of  op- 
erations through  boards  of  directors,  etc.,  are  designed  to 
facilitate  the  accomplishment  of  this  purpose.  Each  person 
who  comes  within  the  organization  also  contributes  of  his  own 
capital.  The  aggregate  of  these  contributions  becomes  the 
capital,  capital  fund,  or  capital  stock  on  hand,  of  the  corpora- 
tion, to  wit,  the  total  amount  of  wealth  which  becomes  ac- 
cumulated in  its  hands  to  be  devoted  to  the  production  of  ad- 
ditional wealth  through  its  enterprise  and  for  the  benefit  of 
the  contributors.  In  reality,  its  capital  is  that  of  the  members, 
and  its  enterprise  is  their  enterprise:  if  it  is  successful,  they 
gain  the  profits;  if  it  fails,  they  lose  their  investment.  Hence, 
in  the  proportion  that  his  contribution  bears  to  the  whole,  each 
contributor  acquires  a  proprietary  interest  in  the  capital  of  the 
corporation  and  the  increment  of  that  capital.  Because  of  ex- 
pediency, and  to  insure  the  continuance  of  the  enterprise  by 
maintaining  intact  its  capital,  the  interest  of  each  member  is 
an  undivided  interest.  The  individual  member  cannot  exer- 
cise direct  dominion  over  any  part  of  the  corporate  assets,  or 
claim  the  personal  use  and  possession  of  any  proportionate 
share,  until  there  is  made  a  lawful  distribution  among  all  the 

31 


32 


CAPITAL   STOCKS 


members,  of  either  the  whole  (as  upon  dissokition)  or  a  part 
(as  the  dividing  of  profits)  of  the  corporate  assets. 

It  is  very  apparent  that  where  there  are  a  number  of  con- 
tributors, the  determination  of  each  one'S(  proprietary  inter- 
est and  the  definition  of  the  extent  to  which  each  may  par- 
ticipate in  the  control  of  the  enterprise  or  share  in  the  dis- 
tribution of  the  capital  or  the  profits,  may  become  a  very 
complicated  matter.  For  uniformity  and  ease  in  this  respect, 
the  measure  of  each  individual  contribution  is  resolved  to  a 
common  denomination.  When  the  total  amount  of  the  capital 
to  be  invested  in  the  corporate  undertaking  has  been  de- 
termined, and  its  collection  from  contributors  has  been  au- 
thorized, that  becomes  the  authorised  capital  stock.  This 
authorized  capital  stock  is  then  divided  into  shares  of  equal 
amounts;  these  are  shares  of  capital  stock,  and  the  amount 
assigned  to  each  share  is  its  par  value.  These  are  incidents  of 
incorporation;  after  incorporation  each  intending  member 
contributes  to  the  capital  of  the  corporation  the  amount  of 
one  or  more  shares;  he  then  becomes  a  stockholder  with  an 
interest  in  the  corporate  enterprise,  in  like  proportion  as  the 
number  of  shares  he  acquires  bears  to  the  total  number  of 
shares  acquired  by  all  the  stockholders,  provided,  of  course, 
that  there  is  no  agreement  modifying  the  relationship.  To 
each  stockholder  the  corporation  executes  a  certificate'  of 
capital  stock,  in  ultimate  effect  tantamount  to  a  receipt,  re- 
citing the  number  of  shares  which  he  has  acquired,  describing 
his  interest  in  the  corporation,  and  defining  the  special  terms 
and  conditions,  if  any,  in  accordance  with  which  that  interest 
will  be  given  effect. 

At  the  outset  of  the  corporate  enterprise,  capital  and  capi- 
tal stock  represent  the  same  substance  considered  in  different 
aspects.  Capital  is  the  sum  of  the  wealth  possessed  and  to  be 
used;  as  such  it  is  an  asset  and  will  be  the  first  item  on  the 
assets  side  of  the  corporate  balance  sheet.  Capital  stock  is 
the  sum  collected  from  stockholders;  it  is  not  and  cannot  be  a 


ISSUE   AND   TRANSFER    OF    CAPITAL   STOCK         33 

debt  of  the  corporation,  but  since  it  represents  the  principal 
sum  of  the  investment  of  the  stockholders  to  be  returned  to 
them  should  the  corporate  enterprise  be  then  or  thereafter 
abandoned,  it  is  a  responsibility,  or  an  accountability,  and  it 
will  be  the  first  item  on  the  liabilities  side  of  the  balance  sheet. 
The  equation  is:  Capital=Capital  Stock.  In  the  second  part 
of  the  equation  capital  stock  is  used  in  the  sense  of  the  aggre- 
gate amount  received  from  the  issue  of  the  shares,  i.e.,  num- 
ber of  shares  times  the  amount  per  share.  Assuming  that 
shares  are  issued  at  par,  the  second  part  of  the  equation  can 
be  changed  to  read  "Par  Value  of  Capital  Stock."  Almost 
immediately,  however,  this  correspondence  between  capital  and 
capital  stock  will  begin  to  be  destroyed;  the  capital  sum  will 
be  increased  or  diminished;  new  assets  will  be  brought  in  and 
liabilities  incurred,  so  that  capital  will  constantly  fluctuate, 
changing  its  form  and  its  value;  capital  stock,  on  the  other 
hand,  will  continue  to  record  the  historical  fact  of  the  total 
capital  contributed,  the  loss  therefrom  or  the  increase  thereto 
being  reflected  in  other  accounts.  The  value  of  the  capital 
stock  will  always  be,  however,  as  it  was  in  the  very  beginning, 
the  value  of  the  net  capital  or  assets  after  allowance  has  been 
made  for  all  liabilities. 

It  must  be  admitted  that  "capital  stock"  Is  not  a  particu- 
larly appropriate  term,  especially  for  accounting  purposes; 
when  analyzed,  its  meaning  cannot  be  distinguished  from  that 
of  "capital,"  and  as  such  it  implies  an  asset  on  hand.  If  it 
were  strictly  Interpreted,  it  would  find  no  place  on  the  liabili- 
ties side  of  the  balance  sheet.  An  individual  conducting  a 
business  of  his  own  records  his  interest  therein  under  the 
usual  caption  of  "proprietorship" ;  that,  however,  shows  his 
actual,  interest  at  the  time  and  differs  in  that  respect  from  the 
corporate  entry  of  capital  stock,  for  the  latter  continues  to 
record  the  capital  originally  contributed,  as  already  noted, 
and  the  actual  existing  interest  of  the  stockholders  can 
be  ascertained  only  by  referring  also  to  the  balance  of  "Cor- 


34  CAPITAL   STOCKS 

porate  Surplus  or  Deficit"  account.  A  better  term  than 
"capital  stock"  may  be  "capital  committed."  The  term  "share- 
holders' capital"  or  "shareholders'  advances"  has  much  to 
commend  it. 

A  share  of  stock  thus  represents  two  things,  first,  a  re- 
ceipt for  a  certain  sum  paid  in;  second,  the  measure  of  the 
holder's  proportionate  fixed  interest  in  the  ownership  of  cor- 
porate property  from  whatever  source  accrued  and  wherever 
found.  The  first  of  these  is  of  transient  and  mainly  historical 
interest ;  the  second  is  that  which  gives  value  to  the  share. 

§  17.    Authority  for  the  Issue  of  Capital  Stock 

The  authorization  of  capital  stock  is  of  the  very  essence 
of  the  organization  of  a  stock  corporation;  it  must,  therefore, 
be  found  in  its  charter.  Where  incorporated  by  special  act, 
the  act  itself  contains  the  authorization  for  capital  stock;  if 
incorporated  under  general  laws,  the  authority  of  the  statute 
is  reflected  in  the  certificate  of  incorporation  by  the  recital 
therein  of  the  amount  of  capital  stock,  the  number  of  shares 
into  which  divided,  the  par  value  of  each  share,  and  the  terms 
of  any  special  agreement  or  provision  limiting  or  extending 
the  interest  represented  by  the  shares  or  by  some  of  them. 
If  some  of  the  shares  of  capital  stock  are  subject  to  limitation 
or  extension  of  interest  or  privilege,  it  must  be  that  all  shares 
are  not  equal;  the  capital  stock  then  contains  different  classes 
of  shares  and  is  said  to  be  classified.  The  purchasers  of  the 
classified  shares  thereafter  take  them  subject  to  the  provisions 
described  in  the  certificate  of  incorporation. 

A  corporation  cannot  issue  any  more  shares  of  stock  than 
are  authorized  in  its  charter.  This  does  not  mean,  however, 
that  its  original  capital  will  be  the  aggregate  par  valuQ  of  the 
shares  issued,  for  while  the  shares  express  a  fixed  par  value, 
they  may  be  sold  at  more  or  less  than  par.  The  issue  at  a 
figure  other  than  par,  of  stock  having  par  value,  is  not  sup- 
ported by  the  theory  of  capital  stock  and  its  relation  to  capital. 


ISSUE   AND   TRANSFER    OF    CAPITAL    STOCK         33 

It  is  very  generally  sought  to  prevent  the  issue  of  stock  at 
less  than  par,  by  statutory  enactments. 

If  more  capital  is  needed  at  any  time  after  the  stock 
originally  authorized  has  been  wholly  issued,  the  corporation 
must  amend  its  charter.  Also  if  it  is  desired  to  reduce  the 
authorized  capital  stock,  the  charter  must  be  amended. 

The  terms  which  we  use  sometimes  confuse  our  ideas. 
We  speak  of  stock  being  issued  by  the  corporation,  and  true 
enough  the  shares  are  issued  by  it,  over  its  seal  and  signatures 
of  its  officials.  It  is  perfectly  clear,  however,  that  the  cor- 
poration can  have  no  control  whatever  over  the  interest  in 
its  own  proprietorship;  that  is  a  matter  which  can  be  con- 
trolled only  by  the  agreement  of  the  proprietors,  just  as  in 
the  case  of  any  other  association  or  partnership.  The  number 
of  partners  or  members  and  their  respective  interests  are  de- 
termined solely  by  the  agreement  of  the  partners  or  members. 
So  also  in  the  corporation,  the  members  themselves  must  de- 
termine the  number  of  shares  in  interest;  they  may  even 
determine  the  number  of  members  by  directing  that  no  more 
than  one  share,  for  instance,  shall  be  held  by  one  member. 
In  the  beginning  the  agreement  is  between  the  incorporators, 
who,  through  the  certificate  of  incorporation,  authorise  the 
corporation  to  issue  a  given  number  of  shares;  the  corporation 
acts  as  an  agent,  practically,  although  with  discretion  and 
judgment  as  to  times  of  issue,  etc.  Every  one  becoming  a 
stockholder  will  be  supposed  to  have  had  full  knowledge  of 
the  agreement  and  to  have  assented  thereto  to  the  extent  that 
the  authorized  number  of  shares  may  be  issued  without  his 
consent  being  specifically  required;  when  the  authorized 
shares  become  exhausted,  however,  the  stockholders  them- 
selves, must  decide  whether  they  will  permit  an  increase  in 
the  number  of  interests,  and  the  conditions  under  which  the 
new  members  will  be  admitted.  The  corporation  itself,  its 
officers  and  directors,  cannot  accomplish  that  result;  it  takes 
the  whole  body  of  the  stock  membership  to  bring  it  about. 


36 


CAPITAL    STOCKS 


§  i8.     Par  Value  of  Capital  Stock 

The  par  value  most  generally  assigned  to  shares  of  stock 
is  $ioo,  but  shares  of  $io,  $25,  and  $50  are  not  uncommon. 
Statutes  permit  a  great  deal  of  latitude;  the  New  York  law 
fixes  a  minimum  of  $5  and  a  maximum  of  $500.  In  some 
continental  countries,  especially  Germany,  the  minimum  par 
value  is  placed  much  higher,  with  the  apparent  purpose  of  re- 
stricting investment  in  shares  to  men  of  means  who  presum- 
ably will  be  better  able  to  suffer  a  reverse  should  the  cor- 
porate enterprise  fail. 

In  view  of  the  great  amount  of  discussion  which  has  taken 
place  concerning  the  utility  of  expressing  a  par  value  on  shares 
of  stock,  it  is  necessary  to  emphasize  the  fact  that  it  was 
originally  merely  an  incident  of  dividing  the  total  capital  stock 
into  equal  parts;  the  practices  and  theories  which  have  since 
grown  up  around  it  and  brought  its  utility  into  question  are 
not  the  necessary  results  of  expressing  a  par  value. 

In  recent  years  the  device  of  stock  without  a  par  value 
has  been  introduced.  The  capital  stock  is  still  divided  into 
shares,  and  an  amount  at  which  the  shares  will  be  offered  for 
sale  must  necessarily  be  determined  beforehand.  To  the  ex- 
tent that  this  amount  represents  the  value  assigned  to  the 
share  for  purposes  of  issue,  it  corresponds  to  the  par  value, 
but  it  will  not  appear  at  all  upon  the  certificate  of  stock,  as  the 
expressed  par  value  would.  The  utility  of  the  device  is  dis- 
cussed in  §  §  36-38. 

§  19.     Certificates  of  Stock 

Capital  stock  represents  proprietorship,  and  the  certificate 
of  stock  is  the  record  of  the  shareholder's  title  and  the  evi- 
dence of  his  right ;  it  is  merely  evidence,  however,  and  is  not 
at  all  essential  to  the  creation  or  maintenance  of  the  relation- 
ship, A  person  becomes  a  stockholder  when  he  purchases  or 
agrees  to  purchase,  or  otherwise  becomes  entitled  to  receive, 
shares  of  stock.     Thus,  the  purchase  for  cash  of  a  share  of 


ISSUE   AND   TRANSFER    OF    CAPITAL   STOCK         37 

Stock,  or  the  rendition  of  services  or  the  transfer  of  property 
pursuant  to  an  agreement  to  accept  payment  in  shares  of  the 
capital  stock,  is  sufficient  to  vest  in  the  purchaser  or  the  ac- 
ceptor of  the  shares  all  of  the  rights  of  a  stockholder. 

The  certificate  of  stock  is  usually  quite  an  elaborate  docu- 
ment, printed,  lithographed,  or  engraved  upon  a  good  quality 
of  paper  to  stand  the  handling,  folding,  and  unfolding  incident 
to  its  use.-^  The  name  of  the  issuing  company,  with  a  note  as  to 
the  state  wherein  incorporated,  the  total  amount  of  the  author- 
ized issue  of  which  the  certificate  evidences  a  part,  the  class 
of  stock  (i.e.,  preferred  or  common)  if  the  company  has  more 
than  one  class  authorized,  and  the  par  value  of  each  share  are 
all  stated  upon  the  certificate.  The  certificate  then  certifies, 
over  the  seal  of  the  company  and  the  signatures  of  its  proper 
officers,  that  the  person  named  therein  is  the  owner  of  the 
stated  number  of  shares  of  the  capital  stock  of  the  company. 
It  also  bears  a  statement  of  the  conditions  under  which  trans- 
fer will  be  recognized  by  the  corporation.  A  blank  form  of 
assignment  to  be  used  in  transferring  the  stock  appears  upon 
the  back  of  the  certificate. 

These  are  the  essential  recitals;  other  provisions  may  be 
added  to  take  care  of  special  conditions;  for  instance,  if  any 
special  conditions  of  preference  attach  to  a  certain  class  of 
stock,  they  will  be  fully  set  forth.  The  form  of  the  certificate 
is  not  material.  A  certificate  of  stock  written  out  by  hand  or 
typewritten  will  be  just  as  good  as  the  most  elaborate  docu- 
ment. In  ordinary  practice  the  certificates  are  printed  in 
blank  form,  and  bound  into  a  stock  certificate  book,  each  cer- 
tificate attached  to  a  stub  which  will  remain  bound  in  the  book 
after  the  certificate  is  detached  therefrom.  The  stub  is  for 
the  record  of  the  serial  number  of  the  certificate,  the  amount 
for  which  it  was  made  out,  date,  name  and  address  of  stock- 
holder, and  if  the  certificate  was  made  out  to  transfer  the 


1  Certificates  of  stock  listed  on  the   New  York   Stock  Exchange  are  required  to  be 
engraved. 


38  CAPITAL    STOCKS 

interest  of  a  former  stockholder,  it  shows  the  name  of  the 
transferor  as  well;  it  will  also  provide  a  form  of  receipt  to 
be  signed  by  the  transferee. 

The  identical  relationship  evidenced  by  the  certificate  of 
stock  may  sometimes  be  expressed  by  a  less  formal  instru- 
ment of  temporary  nature,  as,  for  instance,  temporary  stock 
receipts  which  are  issued  before  the  blank  forms  for  the  certi- 
ficates have  been  prepared.  The  general  recital  of  these  re- 
ceipts is  of  like  tenor  with  that  of  the  certificates  and  they  are 
similar  in  form  and  transferable  in  like  manner.  As  soon  as 
the  certificates  have  been  prepared,  the  receipts  are  exchanged 
for  the  formally  executed  certificates  of  stock. 

Another  form  of  a  temporary  stock  receipt  is  that  issued 
when  stock  is  purchased  by  subscription  and  but  a  part  of  the 
agreed  price  is  paid ;  the  purchaser  does  not  receive  the  certi- 
ficate of  capital  stock  until  it  is  paid  for  in  full,  but  upon  the 
payment  of  each  instalment  he  receives  a  receipt. 

§  20.     Issue  of  Stock 

,  A  share  of  stock  is  issued  when  a  person  becomes  entitled 
to  the  rights  and  privileges  of  a  stockholder  by  performing 
the  conditions  required  of  him.  The  corporation  must  have 
offered  shares  of  stock  for  issue,  and  the  one  desiring  shares 
to  be  issued  to  himself  must  pay  the  amount  required  at  the 
place,  and  in  time  and  manner  specified;  he  then  becomes  a 
stockholder,  although  he  may  not  receive  a  certificate  of  stock 
until  some  time  afterwards. 

The  certificate  is  executed  when  it  has  been  filled  out  with 
the  name  of  the  stockholder,  and  all  the  necessary  signatures 
of  the  corporation's  officers,  together  with  the  corporate  seal, 
have  been  lawfully  affixed. 

The  execution  of  the  certificate  need  not  correspond  to  the 
date  of  issue  of  the  shares  represented  thereby;  it  may  pre- 
cede the  date  of  issue.  For  instance,  a  certificate  may  be 
executed  and  placed  in  escrow  pending  the  fulfilment  of  some 


ISSUE   AND   TRANSFER   OF   CAPITAL   STOCK         39 

further  condition  by  the  purchaser;  when  it  is  finally  de- 
livered it  will  indicate  that  all  requirements  have  been  met,  so 
that  the  stock  is  issued  simultaneously  with  the  delivery  of 
the  certificate.  Execution  of  the  certificates  may  also  follow 
the  date  of  issue,  and  very  often  does. 

To  distinguish  between  the  issue  of  capital  stock  and  the 
ministerial  act  of  executing  and  delivering  the  certificates,  the 
New  York  Public  Service  Commissions,  in  the  forms  pre- 
pared for  annual  reports  of  corporations,  adopted  the  phrase 
"actually  issued"  concerning  the  former,  and  "nominally 
issued"  concerning  the  latter.  These  terms  are  defined  as 
follows: 

"Actually  issued  securities  are  those  which  have  been  de- 
livered to  and  accepted  by  a  bona-fide  purchaser  for  value. 
Where  there  is  a  binding  agreement  between  the  corporation 
and  such  purchaser  whereby  the  corporation  becomes  bound  to 
deliver  and  such  purchaser  becomes  bound  to  accept  the  securi- 
ties, and  all  terms  have  been  settled  and  agreed  upon,  and 
such  purchaser  has  been  accepted  and  is  treated  by  the  cor- 
poration as  a  security  holder  in  respect  of  such  agreement, 
and  all  evidence  required  by  the  Statute  of  Frauds  has  been 
provided,  the  case  may  be  treated  as  one  of  constructive  de- 
livery even  though  the  paper  evidence  has  not  yet  been  turned 
over  to  the  said  purchaser.  A  pledgee  taking  securities  as 
collateral  is  not  to  be  considered  a  bona-fide  purchaser  for 
value,  as  the  phrase  is  above  used  with  respect  to  such  col- 
lateral, until  after  forfeiture  of  the  pledge  or  its  acquisition 
under  foreclosure  proceedings. 

"Where  papers  which  are  securities  in  form  have  been 
prepared  with  the  purpose  of  issuing  them  to  bona-fide  pur- 
chasers for  value,  in  the  preparation  of  which  papers  all 
necessary  entries,  signatures,  sealings,  and  certifications  by 
trustees  have  been  made,  but  the  papers  have  not  yet  been 
actually  issued  (as  defined  in  the  preceding  paragraph),  they 
are  called  'nominally  but  not  actually  issued.'  " 


40 


CAPITAL   STOCKS 


After  stock  has  been  issued,  the  corporation  is  required  by 
law  to  record  the  names  of  the  stockholders  in  a  stock  book 
and  the  detail  in  which  the  information  for  this  book  must 
be  recorded  is  sometimes  specifically  described  in  the  statute. 
In  New  York  it  is  required  that  the  book  shall  contain,  alpha- 
betically arranged,  the  names  of  all  stockholders,  their  places 
of  residence,  the  number  of  shares  held,  date  when  they  be- 
came the  owners  of  those  shares,  and  the  consideration  paid. 
This  book  is  required  to  be  kept  open  daily,  during  three  busi- 
ness hours  at  least,  and  may  be  inspected  by  stockholders  and 
judgment  creditors.  Record  in  this  book  forms  the  basis 
upon  which  the  corporation  will  recognize  its  stockholders. 
Those  who  are  listed  therein  are  the  ''stockholders  of  record." 

In  the  above  definition  of  "actual  issue"  the  reference  to 
the  Statute  of  Frauds  may  require  some  explanation.  The 
Statute  of  Frauds,  so  called,  is  a  series  of  statutory  provisions 
requiring  certain  contracts  to  be  in  writing  in  order  that  they 
may  be  enforcible  at  law.  Apparently  the  provision  here  re- 
ferred to  is  the  one  requiring  a  contract  to  be  in  writing  if  it 
relates  to  the  sale  of  personal  property  for  the  price  of  $50 
(the  New  York  limitation)  or  over,  except  where  the  con- 
tract is  partly  executed  by  part  payment  or  delivery  of  the 
subject  matter  of  the  contract.  The  courts  of  this  country 
have  generally  held  that  shares  of  stock  are  includible  in 
"goods,  wares,  or  merchandise,"  for  the  purpose  of  giving 
effect  to  the  provisions  of  the  Statute.  Where  subscriptions 
must  be  made  in  conformity  with  requirements  of  the  stock 
corporation  laws,  these  provisions  of  the  Statute  of  Frauds 
will  be  inapplicable. 

§  21.     Payment  for  Shares  of  Stock 

It  is  of  the  essence  of  the  relationship  between  the  stock- 
holder and  the  corporation  that  the  former  shall  have  con- 
tributed some  definite  form  of  capital  to  the  proprietorship  of 
the  corporation.     In  the  case  of  stock  having  par  value,  that 


ISSUE   AND   TRANSFER   OF   CAPITAL   STOCK         41 

Stands  as  the  index  of  the  contribution  made  by  each  stock- 
holder; hence  the  general  theory  that  stock  must  always  be 
issued  at  or  above  par,  more  fully  discussed  in  Chapter  IV. 

The  payment  of  the  stockholder  may  be  made  in  cash  or 
in  some  other  form  of  consideration,  such  as  the  rendition  of 
services  or  the  turning  over  of  property  having  actual  de- 
termined value  equalling  the  amount  of  the  contribution  to  be 
made.  The  matter  has  been  generally  subjected  to  statutory 
enactment.  The  New  York  statute  as  to  payment  of  stock 
reads  as  follows: 

"No  corporation  shall  issue  either  stock  or  bonds  except 
for  money,  labor  done,  or  property  actually  received  for  the 
use  and  lawful  purposes  of  such  corporation,  and  may  issue 
stock  to  the  amount  thereof  in  payment  therefor,  and  the 
stock  so  issued  shall  be  full  paid  stock  and  not  liable  to  any 
further  call,  neither  shall  the  holder  thereof  be  liable  for  any 
further  payment  under  any  of  the  provisions  of  this  chapter; 
and  in  the  absence  of  fraud  in  the  transaction  the  judgment 
of  the  directors  as  to  the  value  of  the  property  purchased 
shall  be  conclusive;  and  in  all  statements  and  reports  of  the 
corporation,  by  law  required  to  be  published  or  filed,  this 
stock  shall  not  be  stated  or  reported  as  being  issued  for  cash 
paid  to  the  corporation  but  shall  be  reported  as  issued  for 
property  purchased." 

A  number  of  states  have  carried  similar  provisions  into 
their  constitutions,  while  others  have  enacted  more  or  less 
specific  laws.  The  Constitution  of  the  State  of  Delaware,  for 
instance,  provides  that  "no  corporation  shall  issue  stock,  ex- 
cept for  money  paid,  labor  done,  or  personal  property,  or  real 
estate  or  leases  thereof  actually  acquired  by  such  corporation." 

Payment  other  than  in  cash  is  permitted  by  statute  solely 
to  avoid  the  necessity  of  first  issuing  the  stock  for  cash  and 
then  turning  over  the  proceeds  to  the  purchaser  of  the  stock 
in  payment  for  services  rendered  or  property  transferred  by 
him;  obviously,  therefore,  to  make  a  transaction  bona-fide. 


42 


CAPITAL   STOCKS 


the  services  rendered  or  the  property  transferred  must  have 
been  such  as  the  corporation  would  in  any  event  have  found 
it  necessary  to  obtain.  Nevertheless,  the  dual  relationship  of 
the  parties,  each  being  at  the  same  time  both  vendor  and 
vendee,  may  affect  the  judgment  as  to  the  value  of  the  prop- 
erty or  services,  and  give  occasion  for  practices  prejudicial 
to  the  interests  of  others,  as  is  more  fully  described  in  §  28. 
The  danger  has  been  considered  so  great  that  in  some 
European  countries  the  privilege  of  making  payment  other 
than  in  cash  has  been  restricted  or  subjected  to  special  regu- 
lation. 

In  the  absence  of  a  specific  contract  as  to  method  of  pay- 
ment, it  must  be  made  in  actual  legal  tender  to  be  effective. 
It  may  not  be  made  by  promissory  note  in  whole  or  in  part. 
In  New  York  as  well  as  some  other  states  this  prohibition  is 
carried  into  the  statutory  law;  a  provision  of  the  Penal  Law 
of  New  York  (Section  644)  makes  it  a  misdemeanor  for  a 
director  to  concur  in  any  vote  by  which  it  is  intended  "to  dis- 
count any  note  or  other  evidence  of  debt  in  payment  of  an 
instalment  of  capital  stock  actually  called  in,  and  required  to 
be  paid,  or  with  intent  to  provide  the  means  of  making  such 
payment ;  or  to  receive  or  discount  any  note  or  other  evidence 
of  debt  with  intent  to  enable  any  stockholder  to  withdraw 
part  of  the  money  paid  in  by  him  on  account  of  stock."  To 
permit  payment  by  note  would  open  the  door  to  many  abuses 
of  corporate  finance. 

Stock  is  said  to  be  "full-paid"  when  the  holder  thereof  has 
paid  in,  in  cash  or  other  agreed  form  of  consideration,  an 
amount  equalling  the  par  value  of  the  stock.  Under  proper 
conditions,  e.g.,  pending  completion  of  subscription,  stock  may 
be  issued  and  remain  outstanding  although  not  paid  for  in 
full,  but  so  long  as  it  is  thus  outstanding  the  holder  is  sub- 
ject to  call  of  the  directors  of  the  corporation,  or  the  de- 
mands of  creditors  made  through  proper  judicial  proceedings, 
for  the  balance  due. 


ISSUE   AND    TRANSFER    OF    CAPITAL    STOCK         43 

§  22.     Subscriptions  to  Capital  Stock 

Stock  is  subscribed  for  "where  there  is  a  binding  agree- 
ment between  the  corporation  and  such  purchaser  whereby 
the  corporation  becomes  bound  to  deliver  and  such  purchaser 
becomes  bound  to  accept  the  securities,  and  all  terms  have 
been  settled  and  agreed  upon,  and  such  purchaser  has  been 
accepted  and  is  treated  by  the  corporation  as  a  security  holder 
in  respect  of  such  agreement."  -  In  other  words,  contracting 
to  purchase  shares  of  stock  of  a  corporation  (upon  original 
issue,  of  course,  as  distinguished  from  the  sale  and  transfer 
of  shares  of  stock  from  one  stockholder  to  another)  is  to 
subscribe  to  an  issue  of  capital  stock.  It  should  be  noted  that 
a  subscription  contemplates  a  sale  and  purchase;  a  mere 
promise  to  accept  stock  in  payment  of  services  or  property 
does  not  constitute  a  subscription. 

A  subscription  is  distinguished  from  an  attempt  to  pur- 
chase by  the  tender  of  promissory  notes  in  that  the  subscriber's 
shares  are  admittedly  not  paid  for  in  full  and  he  holds  forth 
his  personal  liability  for  the  balance,  in  default  of  which  he 
would  forfeit  the  amounts  already  paid  in  and  cease  to  be  a 
stockholder;  moreover,  his  liability  is  for  payment  of  the 
balance  or  some  specified  part  thereof  on  call,  unless  other- 
wise agreed,  so  that  the  corporation  may  realize  thereupon  at 
any  time.  A  purchaser  of  stock  who  comes  into  possession 
of  shares  by  the  tender  of  a  promissory  note,  on  the  other 
hand,  if  the  transaction  were  permitted  to  be  valid,  w^ould 
become  the  owner  of  the  shares  absolutely,  his  only  liability 
being  upon  the  note.  If  he  failed  to  pay  this,  the  remedy 
against  him  would  be  through  action  upon  the  note  and  satis- 
faction through  execution,  the  shares  owned  by  him  being 
subject  to  execution  only  as  any  other  class  of  personal  prop- 
erty ow^ned  by  him,  provided  such  shares  were  still  in  his 
possession;  he  could  dispose  of  the  shares  at  any  time  before 


'  From  definitions  contained  in  report  forms  of  Public  Service  Commission,  Second 
District,  New  York. 


44 


CAPITAL   STOCKS 


judgment  and  transfer  valid  title.  Unlike  the  liability  of  the 
subscriber,  the  liability  of  the  debtor  stockholder  cannot  be 
realized  upon  by  the  corporation  until  the  note  falls  due,  un- 
less it  were  a  demand  note. 

Stock  may  be  subscribed  for  before  or  after  incorporation, 
and  usually  any  agreement  which  indicates  clearly  an  intent 
to  become  a  subscriber  will  be  sufficient,  in  the  absence  of 
statutory  regulation.  Certificates  of  incorporation  are  very 
often  required  to  state  "the  name  and  post-office  address  of 
each  subscriber  to  the  certificate  and  the  number  of  shares  of 
stock  he  agrees  to  take."  When  such  a  statement  has  been 
prepared  it  will  be  sufficient  to  create  a  stockholder's  relation- 
ship between  the  corporation  and  the  persons  named,  to  the 
extent  of  the  number  of  shares  entered  against  their  names. 
A  contractual  liability  to  purchase  and  pay  for  the  stock  is 
imposed  upon  each  person  thus  signing  the  certificate.  This 
liability  becomes  effective,  of  course,  only  upon  the  due  filing 
of  the  certificate. 

Preincorporation  subscriptions  are  not  generally  regulated 
by  statute.  In  the  early  days  of  railroad  corporations  there 
were  many  instances  where  commissioners  were  appointed  to 
receive  preincorporation  subscriptions.  If  there  are  two  or 
more  subscribers,  the  subscription  of  each  will  be  the  con- 
sideration for  the  subscription  of  the  others  so  as  to  make 
the  contract  en  forcible  among  themselves  and,  as  a  rule,  they 
can  be  held  to  the  agreement  by  the  corporation.  In  New 
York,  however,  if  the  contract  is  to  be  also  enforcible  by  the 
corporation  as  a  party  to  the  contract,  it  is  necessary  that  the 
agreement  of  the  subscribers  be  to  subscribe  to  a  number  of 
shares  of  stock  and  to  form  a  corporation.  If  the  express 
intent  of  forming  a  corporation  is  not  stated  in  the  agree- 
ment, the  corporation  upon  coming  into  existence  is  deemed  a 
stranger  to  the  contract  and  may  not  itself  sue  to  recover 
upon  the  agreement,  although  undoubtedly  the  subscribers 
who  carried  out  their  contract  may  maintain  action  against 


ISSUE  AND  TRANSFER   OF   CAPITAL   STOCK 


45 


those  committing  a  brea-ch,  provided  the  former  had  reHed 
upon  the  subscriptions  of  the  latter  and  had  incurred  liabili- 
ties accordingly.  To  permit  recovery  by  the  company,  formal 
subscription  after  incorporation  is  necessary. 

Subscriptions  made  after  incorporation  must  conform  to 
the  method  prescribed  by  statute.  The  New  York  statute 
provides  that:  "At  the  time  of  subscribing,  every  subscriber, 
whose  subscription  is  payable  in  money,  shall  pay  to  the  direc- 
tors ten  per  centum  upon  the  amount  subscribed  by  him  in 
cash,  and  no  such  subscription  shall  be  received  or  taken  with- 
out such  payment." 

The  contract  of  subscription  may  specify  each  date  when 
further  payments  are  required  to  be  made;  if  there  is  no 
specific  provision,  further  payments  will  be  due  as  and  when 
"called"  by  the  board  of  directors. 

§  23.    Transfer  of  Certificates  of  Stock 

Transfers  of  stock  may  be  made  at  the  corporate  office, 
where  some  officer,  generally  the  treasurer  or  an  assistant 
treasurer,  issues  new  certificates  for  the  old  ones  when  pre- 
sented. Corporations  having  large  issues  of  capital  stock 
outstanding,  the  shares  of  which  are  heavily  dealt  in  on  the 
market  and  changing  ownership  frequently,  will  appoint  some 
person,  banking  house,  or  trust  company  as  transfer  agent, 
deposit  with  him  the  book  of  blank  certificates  and  the  cor- 
porate seal,  and  authorize  him  to  make  transfers  of  stock  by 
issuing  new  certificates  for  the  old  ones  upon  presentation. 
The  blank  stock  certificates  deposited  with  him  are  properly 
signed  by  the  treasurer  and  president  or  vice-president  of  the 
corporation,  but  they  do  not  become  valid  unless  countersigned 
upon  issue  by  the  transfer  agent  and  sealed  with  the  corpor- 
ate seal. 

Corporations  issuing  "registered  stock"  also  provide  a 
registrar  whose  countersignature  is  likewise  necessary  to  the 
validity  of  the  certificate.     Registered  stock  differs  from  the 


46  CAPITAL   STOCKS 

ordinary  stock  in  that  upon  transfer  of  the  certificate,  in  addi- 
tion to  the  signature  of  the  owner  on  the  back  of  the  certi- 
ficate, his  signature  (made  personally  or  by  one  authorized  to 
sign  for  him)  is  also  necessary  on  books  maintained  for  that 
purpose  by  the  registrar. 

Shares  of  stock  are  evidences  of  interest  or  right,  and 
they  may  be  transferred  by  assignment  in  writing.  A  blank 
form  of  assignment  is  usually  printed  on  the  back  of  the  cer- 
tificate, as  a  matter  of  convenience.  To  transfer  any  part  or 
all  of  the  shares  represented  by  the  certificate,  the  holder 
thereof  fills  in  the  name  of  the  transferee,  specifying  the 
number  of  shares  to  be  transferred,  and,  having  had  his  own 
signature  witnessed,  sends  the  certificate  to  the  transfer  agent. 
He  may  also  name  some  person  as  his  attorney  ^  for  the  pur- 
poses of  transfer,  in  which  case  that  person  must  appear  in 
person  to  request  the  transfer;  usually  this  space  is  left 
blank  and  the  transfer  clerk  will  then  insert  his  own  name. 
The  transfer  agent  must  cancel  the  returned  certificate  and  in 
place  thereof  issue  to  each  transferee  a  certiiicate  for  the 
number  of  shares  ordered,  and  if  the  total  number  of  shares 
represented  by  the  original  certificate  returned  to  him  is  not 
to  be  transferred,  he  executes  to  the  owner  a  new  certificate 
for  the  number  of  shares  retained.  The  transferees  there- 
upon become  stockholders  of  record  and  their  names  are 
entered  upon  the  stock  book. 

If  the  holder  of  the  certificate  does  not  specify  the  name 
of  any  transferee,  he  is  said  to  have  transferred  in  blank  and 
the  certificate  may  pass  from  hand  to  hand  without  the  neces- 
sity of  a  new  one  being  issued  each  time.  Any  holder  may, 
of  course,  fill  in  his  own  name  and  present  the  certificate  for 
transfer  on  the  records.  It  must  always  be  remembered  that 
the  holder  whose  name  appears  upon  the  record  is  the  one 
recognized  by  the  corporation  and  if  any  dividends  are  de- 


^  Such  a  person  need  not  be  a  lawyer;  the  term  here  refers  to  an  attorney-in-fact, 
i.e.,  one  acting  as  the  agent  of  another  in  the  doing  of  a  particular  act. 


ISSUE   AND   TRANSFER    OF    CAPITAL   STOCK 


47 


clared  in  the  meantime  these  will  be  paid  to  him.  The  divi- 
dends, of  course,  really  belong  to  the  actual  owner  of  the 
shares  who  may  demand  them  from  the  stockholder  of  record, 
but  the  owner  of  the  shares  will  not  be  entitled  to  demand 
payment  from  the  corporation  without  first  having  the  trans- 
fer recorded.  On  the  other  hand,  if  the  corporation  fails 
under  circumstances  which  impose  a  liability  upon  the  stock- 
holders, the  holder  of  record  will  be  liable  even  though  he  is 
no  longer  the  owner  of  the  shares. 

The  certificate  itself  calls  attention  to  the  necessity  of 
transfer  upon  the  books,  in  its  recital  that  the  shares  repre- 
sented are  "transferable  only  on  the  books  of  the  company, 
in  person  or  by  attorney,  on  surrender  of  this  certificate." 
It  is  not  to  be  forgotten,  however,  that  as  between  the  trans- 
feror and  transferee,  the  transfer  is  valid  and  effective  to 
pass  title  upon  delivery  of  the  certificate  properly  indorsed. 
The  transfer  upon  the  books  is  for  the  protection  of  the  cor- 
poration, and  to  relieve  the  transferor  of  liability  as  a  stock- 
holder to  the  creditors  of  the  corporation. 

An  agreement  among  all  the  stockholders  limiting  the 
right  of  transfer  will  be  binding;  such  a  limitation  may  be 
placed  in  the  certificate  of  incorporation  or  covered  by  separ- 
ate agreement.  In  every  case,  however,  the  limitation  must 
be  reasonable  and  it  must  not  amount  to  an  absolute  restric- 
tion; the  courts  are  careful  to  guard  the  transferability  of 
the  shares,  for  this  represents  a  valuable  and  essential  char- 
acteristic of  corporate  organization. 

Shares  of  stock  are  the  personal  property  of  the  owner 
which  he  may  dispose  of  as  he  will,  and  the  corporation  or 
its  transfer  agents  are  bound  to  make  the  transfer  and  recog- 
nize the  transferee  as  a  stockholder,  in  the  absence  of  any 
legal  restraint  operating  upon  the  corporation  and  permitting 
it  to  refuse  record  of  the  transfer.  The  Public  Service  Com- 
missions Law  of  New  York,  for  instance,  describes  certain 
conditions  under  which  one  public  utility  may  not  become  a 


48 


CAPITAL   STOCKS 


stockholder  in  another  without  the  consent  and  authorization 
of  the  Commission;  to  make  this  prohibition  effective,  it 
further  provides  that  the  corporation  whose  stock  is  the  sub- 
ject of  the  prohibited  transfer  shall  not  record  the  transfer 
upon  its  books  and  shall  not  issue  certificates  of  stock  there- 
for. 

When  payment  of  a  tax  is  required  upon  transfers  of 
shares  of  stock,  it  must  be  paid  before  transfer  can  be  recorded 
upon  the  books;  moreover,  the  corporation  is  required  to 
keep  such  record  of  the  transfers  as  will  enable  the  state  au- 
thorities to  check  up  payments.  The  New  York  statute  re- 
quires every  corporation  to  keep  a  stock  certificate  book  and 
a  just  and  true  book  of  account,  transfer  ledger  or  register, 
in  such  form  as  may  be  prescribed  by  the  comptroller,  wherein 
shall  be  plainly  and  legibly  recorded  in  separate  columns  the 
following: 

"i.    The  date  of  making  every  transfer  of  stock. 

2.  The  name  of  the   stock  and  the  number  of  shares 

thereof. 

3.  The  serial  number  of  each  surrendered  certificate. 

4.  The  name  of  the  party  surrendering  such  certificate. 

5.  The  serial  number  of  the  certificate  issued  in  exchange 

therefor. 

6.  The  number  of  shares  covered  by  said  certificate. 

7.  The  name  of  the  party  to  whom  said  certificate  was 

issued. 

8.  Evidence  of  the  payment  of  the  tax  provided  for  (i.e., 

the  number  and  face  value  of  the  stamps  affixed)."* 

Surrendered  or  cancelled  certificates  and  all  other  records 
or  memoranda  relating  to  sales  or  transfers  must  be  kept  for 
a  period  of  two  years  at  least,  under  the  provisions  of  the 
New  York  statute. 


*  Consolidated  Tax  Law,   Section  276.     The  tabular  arrangement  is  here  used  for 
convenience;  it  is  not  found  in  the  original. 


ISSUE   AND   TRANSFER    OF    CAPITAL    STOCK 


49 


§  24.     Certificates  of  Stock  as  Negotiable  Instruments 

The  ease  with  which  certificates  of  stock  are  transferred, 
and  the  many  uses  made  of  them  in  ordinary  commercial  trans- 
actions sometimes  give  the  suggestion  that  they  are  negotiable 
paper.  The  significant  characteristic  of  negotiable  paper  is 
that  it  can  be  transferred  by  delivery  or  indorsement  and  the 
transferee  will  acquire  good  title,  provided  all  the  conditions 
prescribed  by  statute  obtain,  irrespective  of  any  defect  of  title 
in  the  transferor.  Such  an  instrument,  however,  is  required 
to  contain  an  unconditional  order  or  promise  to  pay  a  cer- 
tain sum  of  money,  and  certificates  of  stock  are  not  securities 
for  money;  they  do  not  represent  a  debt  and  cannot,  in  the 
very  nature  of  the  case.  However,  although  they  do  not 
technically  become  negotiable  instruments,  stock  certificates 
have  been  assigned  a  great  degree  of  negotiability,  and  "inno- 
cent parties  dealing  in  them  will  be  protected  upon  analogous 
principles,  and,  in  a  proper  case,  will  be  entitled  to  compel 
recognition  as  stockholders,  where  power  exists  to  issue  new 
certificates,  or  to  indemnity  if  there  is  not."  ^ 

"Certificates  of  stock  are  not  negotiable  in  form;  they 
represent  no  debt  and  are  not  securities  for  money;  but  the 
courts  of  this  country,  in  view  of  the  extensive  dealings  in 
certificates  of  shares  in  corporate  enterprises,  and  the  interest 
both  of  the  public  and  of  the  corporation  which  issues  them  in 
making  them  readily  transferable  and  convertible,  have  given 
to  them  some  of  the  elements  of  negotiability."  ^  In  legal 
phrase,  they  are  quasi  negotiable. 

An  essential  requirement  of  notes  which  are  to  circulate 
as  negotiable  instruments  is  that  they  must  be  payable  to 
bearer  or  order,  and  correspondingly,  to  enjoy  the  greatest 
measure  of  negotiability  of  which  they  are  capable,  certificates 
of  stock  must  also  be  made  payable  to  order  or  bearer.  The 
form  of  the  certificate  itself  does  not  permit  of  this,  and  the 


=  Jarvis  v.  Manhattan  Beach  Co..  148  N.  Y.  652. 
•Knox  V.  Eden  Music  Co.,  14S  N.  Y.  441. 


50 


CAPITAL   STOCKS 


only  way  in  which  this  can  be  accomplished  is  by  indorsement 
in  blank. 

"While  certificates  of  stock  do  not  possess,  in  full,  the 
quality  of  commercial  paper,  yet  when  the  transfer  indorsed 
thereon  is  signed  in  blank  by  the  shareholder  named  therein, 
they  become,  so  far  as  the  public  is  concerned,  as  if  they  had 
been  issued  to  bearer."  ^ 

In  England  and  the  United  States,  "bearer  shares"  are 
not  customary,  in  fact,  they  are  not  provided  for  by  statute, 
while  in  Germany,  France,  and  other  continental  countries 
they  are  quite  usual.  "Bearer  shares"  correspond  in  form 
to  our  coupon  bonds.  Shares  of  stock  corresponding  to  the 
form  of  our  ordinary  certificates  are  known  in  those  countries 
as  "nominative  shares,"  or  the  two  forms  are  sometimes  dis- 
tinguished by  calling  the  one  "shares  to  name"  and  the  other 
"shares  to  bearer."  Bearer  shares  can  be  freely  negotiated 
without  transfer  on  the  books  of  the  corporation,  so  that  the 
holders  of  the  shares  are  not  known  to  the  corporation  until 
the  coupons  attached  to  the  shares  have  been  presented  for 
the  payment  of  dividends  declared.  Bearer  shares  may  be 
converted  into  nominative  shares  and  vice  versa. 

The  Uniform  Stock  Transfer  Act,  so  called,  enacted  with 
slight  changes  by  a  number  of  the  larger  states,  describes  the 
warranties  of  the  transferor  of  stock.  In  New  York  these 
provisions  are  carried  into  the  Personal  Property  Law  and 
the  particular  section  (172)  reads  as  follows: 

"A  person  who  for  value  transfers  a  certificate,  including 
one  who  assigns  for  value  a  claim  secured  by  a  certificate, 
unless  a  contrary  intention  appears,  warrants — 

(a)  That  the  certificate  is  genuine, 

(b)  That  he  has  a  legal  right  to  transfer  it,  and 

(c)  That  he  has  no  knowledge  of  any  fact  which  would 

impair  the  validity  of  the  certificate. 


'  Fifth  Ave.  Bk.  v.  Forty-second  St.  and  Grand  Ferry  R.  R.  Co.,  137  N.  Y.  23.T. 


ISSUE   AND   TRANSFER    OF    CAPITAL    STOCK         51 

"In  the  case  of  an  assignment  of  a  claim  secured  by  a  cer- 
tificate, the  liabiHty  of  the  assignor  upon  such  warranty  shall 
not  exceed  the  amount  of  the  claim." 

§  25.     Shares  of  Stock  Taxed  as  Personal  Property 

Shares  of  stock  are  choses  in  action,  representing  an  in- 
corporeal right  vested  in  the  owner  of  the  shares;  they  are  thus 
considered  as  personal  property  even  though  the  corporate 
assets,  ownership  whereof  is  represented  by  the  shares,  may 
consist  wholly  of  real  property. 

It  is  well  established  that  shares  of  stock  may  be  taxed  as 
personal  property  of  the  stockholder.  The  exercise  of  the 
power  to  tax,  however,  is  subject  to  many  considerations  of 
equity  and  fairness.  In  spite  of  the  distinction  between  the 
stockholder's  property  rights  in  the  shares  and  the  corpora- 
tion's property  rights  in  the  corporate  assets,  the  taxation  of 
shares  must  be  considered  as  but  one  aspect  of  the  general 
problem  of  taxing  corporate  properties  and  enterprises — as 
complicated  a  problem  as  may  be  found.  There  are  many 
methods  of  levying  taxes  upon  corporations.  There  are  al- 
ways the  usual  taxes  on  realty  and  personalty  owned  by  the 
corporation.  Then  the  corporate  franchise  may  be  taxed;  so 
also  the  income  or  profits,  or  else  the  levy  may  relate  to 
the  capital  stock  (the  tax  to  be  paid  by  the  corporation),  or 
to  the  shares  of  stock  in  the  hands  of  stockholders  and  to  be 
paid  by  them  individually;  or,  again,  the  shares  of  stock  may 
be  taxed,  payment  of  the  tax  being  made  by  the  corporation  in 
the  first  instance  and  in  turn  collected  from  the  stockholders. 

Taxes  levied  upon  shares  of  stock  must  not  be  confused 
with  taxes  upon  the  capital  stock.  It  has  been  held  that  a  tax 
upon  the  capital  stock  is  actually  upon  the  property  of  the 
corporation,  placing  a  somewhat  different  meaning  upon  the 
term  from  that  usually  assigned  to  it ;  it  has  been  further  held 
that  this  remains  true  even  though  the  value  of  the  capital 
stock  for  purposes  of  taxation  is  taken  as  the  aggregate  of 


52  CAPITAL   STOCKS 

the  value  of  the  shares.  To  distinguish  a  tax  upon  the  shares, 
it  is  said  that  the  legal  property  of  the  shareholder  is  entirely 
separate  and  distinct  from  the  property  of  the  corporation 
even  though  the  value  of  the  former  depends  upon  the  value 
of  the  latter. 

The  chief  objection  to  the  exercise  of  the  right  is  that  it 
almost  inevitably  results  in  double  taxation  which  is  not 
favored  either  in  law  or  economics.  The  state  has  the  right 
to  levy  double  or  even  treble  taxes,  but  unless  it  is  a  measure 
of  emergency  the  levy  of  such  taxes  is  considered  an  abuse 
rather  than  the  proper  use  of  authority,  and  in  some  instances, 
therefore,  states  seek  to  prevent  double  taxation  by  constitu- 
tional limitations.  The  danger  can  be  obviated  only  by  de- 
ducting from  the  taxable  value  of  the  shares  the  taxed  value 
of  the  corporate  properties ;  the  excess  is  then  regarded  as  the 
untaxed  intangible  value  of  the  stockholders'  interest.  The 
same  principle  holds  true  in  the  taxation  of  capital  stock, 
where  it  is  easier  of  operation.  There  are  perhaps  not  more 
than  four  states  which  assess  shareholders  wholly  irrespective 
of  other  corporation  taxes;  these  are  Delaware,  Georgia, 
Louisiana,  and  Washington.  Maryland,  the  District  of  Co- 
lumbia (in  a  measure),  Alabama,  and  Iowa  assess  share- 
holders on  that  part  of  the  value  of  their  stock  which  repre- 
sents the  excess  of  market  value  of  the  shares  over  the  assessed 
value  of  the  corporate  properties.  In  all  other  states  shares 
of  stock  are  not  assessed  against  the  stockholders  when  the 
issuing  corporation  or  its  property  is  directly  taxed.  The  New 
York  statute  provides  that  "the  owner  or  holder  of  capital 
stock  in  an  incorporated  company  liable  to  taxation  on  its 
capital  shall  not  be  taxed  as  an  individual  for  such  stock." 

Personal  property  follows  the  domicile  of  the  owner;  thus, 
a  state  acquires  the  right  to  tax  the  shares  of  stock  of  a 
foreign  corporation  when  held  by  a  person  residing  in  that 
state.  It  would  therefore  seem  that  the  state  wherein  the 
corporation  was  incorporated  would  lose  the  power  of  taxing 


ISSUE  AND   TRANSFER   OF   CAPITAL   STOCK 


53 


shares  in  that  corporation  if  they  were  held  by  persons  re- 
siding in  other  states,  but  on  this  point  it  is  held  that  the 
common  law  rule  which  permits  personal  property  to  follow 
the  owner  can  be  amended  by  statute  in  respect  of  shares  of 
stock  so  that  the  situs  of  the  shares  may  be  fixed,  for  the  pur- 
poses of  taxation,  at  the  location  of  the  corporation.  The 
method  of  collection  under  the  latter  circumstances  is  that  of 
collecting  the  tax  from  the  corporation  and  empowering  it  to 
collect  from  the  stockholders. 

Upon  organization  of  corporations  most  states  collect  a 
tax  upon  the  authorized  capital  stock,  collecting  a  similar  tax 
upon  future  increases.  This  tax  should  not  be  confused  with 
the  annual  tax  upon  capital  stock,  where  one  is  levied. 


CHAPTER   IV 

RELATION  OF  PAR  VALUE  TO  PRICE  OF  ISSUE 
AND    VALUE    OF    STOCK 

§  26.     Capital  Stock  to  be  Issued  at  Par 

The  logical  and  necessary  consequence  of  the  general 
theory  of  capital  stock  issues  discussed  in  the  foregoing  chap- 
ter is  that  shares  of  capital  stock  must  be  issued  at  par.  If 
there  has  not  been  "complete  compliance  with  that  requirement 
there  has  not  been  that  initial  identity  between  capital  and 
capital  stock  which  should  have  characterized  the  first  stage 
in  the  development  of  the  corporate  enterprise.  In  theory 
that  identity  begins  to  be  destroyed  almost  the  very  instant 
that  it  is  established,  for  capital  is  subject  to  constant  change, 
while  capital  stock  continues  to  be  held  forth  as  the  measure 
of  that  original  equality — if  the  enterprise  has  not  been  con- 
ducted at  a  loss  it  will  also  represent  the  minimum  of  the 
corporation's  equity,  i.e.,  the  excess  of  its  assets  over  the 
liabilities  (capital  stock  itself  not  being  a  liability)  ;  if  it  has 
been  conducted  at  a  loss,  capital  stock  will  serve  to  measure, 
by.  the  comparison  between  the  corporation's  present  equity 
and  its  own  par  value,  the  impairment  of  original  capital. 

Significance  of  Par  Value  of  Outstanding  Shares.  But, 
after  it  has  served  its  original  purpose  of  establishing  the 
price  of  issue,  is  there  any  real  reason  why  the  capital  stock 
should  continue  to  be  stated  at  par  value?  The  corporation 
is  under  no  obligation  for  the  par  of  the  stock  to  the  stock- 
holders or  to  anyone  else.  The  stockholders'  interest  is  that 
of  proprietorship,  the  value  of  which  is  a  fluctuating  amount; 
carrying  the  stock  at  par  does  not  make  it  any  easier  to  de- 
termine that  value,  but  in  fact  makes  it  more  difficult.     It  is  a 

54 


PAR  VALUE  AND  VALUE  OF  STOCK 


55 


fact  not  generally  pointed  out  that  the  appearance  of  capital 
stock  at  par  upon  the  balance  sheet,  when  other  figures  neces- 
sary to  the  computation  of  the  real  amount  of  proprietorship 
are  scattered  under  various  designations,  has  been  the  means 
of  more  misinformation  as  to  the  real  value  of  the  stock  than 
perhaps  all  the  misstatements  of  those  interested  in  hiding 
the  facts. 

From  the  viewpoint  of  the  stockholders  one  reason  for 
carrying  stock  on  the  books  at  par  is  that  the  original  issue 
of  the  stock  represented  investments  made  by  those  who  pur- 
chased the  shares.  A  basic  principle  of  investment  is  that  the 
amount  put  out  shall  be  income-producing  during  the  period 
of  investment  and  be  returned  undiminished  at  the  expiration 
of  that  period.  Accordingly  it  may  be  contended  plausibly 
that  the  par  value,  representing  the  original  investment  of  the 
stockholders,  shall  be  carried  continuously  as  a  historical  fact, 
so  that  by  comparison  with  other  facts  a  conclusion  may  be 
reached  as  to  the  fidelity  or  success  with  which  the  corporation 
is  administering  the  stockholders'  investment.  Another  reason 
is  that  the  amount  of  proprietorship  may  be  increased  either 
by  the  profits  retained  in  the  business  or  by  the  payments  on 
new  issues  of  stock;  in  the  first  situation  the  value  of  each 
share  of  stock  is  increased,  while  it  is  not  necessarily  affected 
in  the  second  situation.  Neither  of  these  reasons,  however, 
is  such  as  to  require  imperatively  the  carrying  of  stock  at  par 
upon  the  current  books  of  the  corporation.  Memorandum 
entries  could  easily  be  made  to  suffice. 

Where  there  is  an  issue  of  stock  preferred  as  to  prin- 
cipal, so  that  upon  distribution  of  the  corporate  assets  it  will 
be  entitled  to  receive  its  par  value  before  the  common  stock 
may  be  allowed  to  participate,  then  the  current  record  of  the 
par  value  of  the  preferred  stock  becomes  a  matter  of  import- 
ance. 

The  "Trust  Fund"  Theory.  Apart  from  the  stockholders' 
interest,  the  par  value  of  the  stock  has  been  taken  as  the  index 


56  CAPITAL   STOCKS 

of  the  corporate  financial  responsibility — the  basis  of  credit, 
so  that  the  rights  of  creditors  may  be  said  to  be  violated  if 
the  capital  stock  has  been  issued  under  circumstances  which 
have  withheld  from  the  corporation  the  full  measure  of  capital 
intended  to  be  represented  by  the  par  value  thereof.  This  is 
the  "trust  fund"  theory,  holding  that  the  capital  stock  repre- 
sents a  fund  provided  and  maintained  for  the  protection  of 
creditors.  Evidence  as  to  the  condition  of  the  trust  fund  is 
thus  considered  to  be  essential  information  for  the  guidance 
of  creditors.  The  "trust  fund"  theory  as  the  basis  of  de- 
termining the  legal  status  of  stock  is  no  longer  given  effect, 
but  during  the  period  when  it  was  operative  it  caused  the 
adoption  of  practices  which  have  since  continued.  It  is  well 
to  note  in  passing  that  credit,  both  personal  and  corporate,  de- 
pends as  much,  if  not  more,  on  a  record  of  achievement  as  it 
does  on  the  possession  of  valuable  property  assets,  and  the 
one  who  is  to  extend  credit  to  the  corporation  is  very  much 
interested  in  noting  the  extent  to  which  the  corporation  has 
been  able  to  maintain  the  integrity  of  the  stockholders'  in- 
vestment. 

Limited  Liability  of  Stockholders.  Stockholders  are  not 
liable  for  corporate  debts  beyond  the  par  value  of  the  stock, 
and  if  the  par  value  has  been  paid  in,  creditors  (except  em- 
ployees for  wages  remaining  unpaid  after  judgment  and 
execution  against  the  corporation)  have  no  recourse  against 
the  stockholders.  The  sole  purpose  of  incorporating  a  very 
large  number  of  more  or  less  personal  enterprises  is  that  of 
securing  for  the  owners  thereof  the  protection  of  the  limited 
liability  thus  provided  by  law.  If  the  benefits  of  the  law  are 
to  be  taken  advantage  of,  its  obligations  also  must  be  assumed ; 
hence  the  general  rule  of  law,  even  in  the  absence  of  specific 
statutory  requirement,  that  capital  stock,  if  it  is  to  be  "full- 
paid"  so  as  to  relieve  the  holder  from  further  liability,  must 
be  issued  at  not  less  than  par.  A  person  purchasing  it  at  less 
from  the  corporation  on  original  issue,  whether  under  secret 


PAR  VALUE  AND  VALUE  OF  STOCK 


57 


agreement  or  by  direct  resolution  of  the  board  of  directors  of 
the  corporation  authorizing  the  issue,  will  be  deemed  in  the 
theory  of  the  law  to  have  accepted  the  stock  subject  to  an 
agreement  to  pay  the  difference  between  the  purchase  price 
and  the  par  value  should  the  claims  of  creditors  require  the 
deficiency  to  be  made  good.  Moreover,  the  state  may  institute 
proceedings  to  forfeit  the  charter  of  the  corporation,  provided 
some  public  interest  has  been  jeopardized.  This  is  a  very 
general  statement  of  the  rule  and  its  practical  application 
causes  many  modifications  and  qualifications.  For  instance, 
in  some  states  a  stockholder  receiving  stock  as  bonus  is  liable 
upon  a  proper  demand  for  payment,  while  in  New  York  and 
other  states  a  different  principle  is  applied.  The  basis  of  the 
New  York  rule  is  that  the  issue  of  stock  is  a  contract,  and  if 
it  has  been  issued  at  less  than  par  the  court  cannot  later  amend 
the  contract  so  as  to  require  the  stockholder  to  make  a  further 
payment  which  he  never  agreed  to  make ;  the  remedy  is  that 
of  ordering  rescission,  and,  following  the  rules  of  contracts, 
both  parties  are  to  be  restored  to  their  original  position  as 
nearly  as  may  be,  viz.,  the  property  or  value  given  by  the  stock- 
holder must  be  returned  to  him,  and  the  stock  issued  by  the 
corporation  or  the  value  thereof  must  be  returned  by  the  one 
who  received  it.  The  presence  or  absence  of  fraud,  the 
knowledge  on  the  part  of  those  extending  credit  that  the  stock 
had  not  been  issued  for  full  value,  and  any  number  of  special 
considerations  will  affect  the  operation  of  the  rule  in  specific 
cases. 

Issue  at  Par  to  Avoid  Inflation.  Capital  stock  issues 
are  sometimes  described  as  mediums  of  credit,  so  that  the  issu- 
ance of  the  stock  at  less  than  par  would  represent  the  inflation 
of  credit  and  involve  the  possibility  of  the  same  ultimate 
results  should  the  credit  collapse.  Supposing  that  upon  the 
failure  of  the  corporation  the  stockholders  were  the  same  as 
those  to  whom  the  shares  were  originally  issued,  their  loss 
would  not  be  any  more  or  less  because  of  the  par  value  speci- 


58  CAPITAL    STOCKS 

fied  in  the  shares,  hut  would  be  measured  solely  by  the  actual 
amount  of  their  investment.  The  situation  would  be  far 
different,  however,  if  the  shares  originally  held  by  these  stock- 
holders had  been  transferred  and  retransferred,  each  succeed- 
ing holder  paying  a  higher  price  than  had  his  predecessor, 
more  nearly  approaching  if  not  exceeding  par.  The  invest- 
ment of  the  stockholders  at  the  time  of  the  failure  would  then 
be  greater  than  the  investment  of  the  original  stockholders  as 
represented  by  their  contributions  to  the  corporate  capital. 
The  contention  of  those  who  follow  this  theory,  that  stock  be 
issued  at  par,  takes  into  consideration  incidents  in  the  life  of 
the  shares  after  the  original  issue — an  eminently  proper  con- 
sideration. 

§  27.     Watered  Stock 

Stock  which  purports  to  be  full-paid  but  which  is  actually 
issued  for  no  direct  consideration  or  for  a  consideration  much 
less  than  par  is  said  to  be  "watered" — the  corporation  is  over- 
capitalized; it  has  outstanding  more  certificates  of  capital- 
contributions  than  it  has  capital.  Overcapitalization  may  also 
result  from  the  inflation  of  capital-indebtedness.  The  prob- 
lems arising  from  both  conditions  closely  resemble  each  other. 

The  problem  of  watered  stock  has  always  been  a  perplex- 
ing one.  The  practice  has  been  generally  condemned;  it  has 
been  repeatedly  attacked ;  it  has  been  legislated  about  and 
sought  to  be  legislated  out,  but  not  only  does  it  continue  to 
remain  with  us  but  it  is  still  able  to  find  its  champions  and 
advocates  and  the  recent  trend  towards  allowing  the  issue  of 
stock  at  discount  must  l^e  admitted  to  be  a  recognition,  in 
some  measure  at  least,  of  the  justice  of  some  of  the  argu- 
ments which  have  been  adduced  in  justification  of  the  practice. 

Stock- watering  appears  in  many  forms,  e.g.,  in  the  issue 
of  stock  as  bonus  to  purchasers  of  bonds,  in  "stock  dividends" 
based  on  superficial  valuations,  in  the  issue  of  an  insufficient 
consideration  consisting  of  property  or  services  to  which  a 


PAR  VALUE  AND  VALUE  OF  STOCK 


59 


fictitious  value  is  assigned,  and  even  for  a  cash  consideration 
representing  but  a  fraction  of  the  par  value. 

The  facility  with  which  stock  may  be  transferred  to  others 
has  been  a  great  source  of  temptation  to  "water"  it.  The  per- 
son acquiring  a  block  of  shares  for  practically  nothing  or  for 
a  very  small  consideration  can  turn  around  and  sell  his  shares 
to  others  who  rely  upon  the  presumption  of  par  value  ap- 
proximating original  investment.  He  may  thus  realize  excep- 
tionally large  and  quick  profits,  and  at  the  same  time  divest 
himself  of  all  interest  in  the  corporation  and  transfer  to  others 
the  burden  of  making  up  the  deficiency,  while  he  would  not, 
except  in  an  especially  unconscionable  transaction,  be  answer- 
able to  those  he  has  induced  to  purchase  the  stock.  True,  the 
purchaser  may  be  cunning  or  clever  enough  to  protect  his  own 
larger  investment  by  placing  upon  the  customers  of  the  enter- 
prise the  burden  of  paying  charges  sufficient  to  compensate 
him,  but  it  would  simply  postpone  the  day  of  reckoning, 
unless,  happily,  he  were  willing  to  put  back  into  the  enter- 
prise enough  of  his  profits  to  make  up  the  original  deficiency. 

Stock  is  seldom  "watered"  by  an  issue  for  cash  at  less  than 
par,  because  the  facts  would  be  too  obvious.  Instead,  methods 
have  been  devised  which  command  the  semblance  of  legality 
while  affording  sufficient  opportunity  to  disguise  the  true 
nature  of  the  transaction  and  to  make  proof  of  fraudulent 
intent  difficult. 

§28.     (i)  Stock  Issued  for  Property  or  Services 

The  most  common  device  for  watering  stock  is  to  issue 
stock  for  property  or  services.  This  has  proved  exceptionally 
convenient,  not  only  because  the  statutes  expressly  permit  the 
exchange  for  property  or  services,  but  also  because  they  make 
conclusive  the  judgment  of  the  directors  as  to  the  value  of 
the  properties  accepted  in  exchange,  provided,  of  course,  there 
is  no  actual  fraud.  Where  the  directors  represent  the  pro- 
moters or  the  controlling  stockholders  who  are  also  interested 


6o  CAPITAL    STOCKS 

in  the  sale  of  property  to  the  corporation,  the  determination 
of  those  directors  as  to  the  value  of  the  property  is  apt  to  rest 
solely  upon  the  statements,  or  be  responsiveto  the  desires,  of 
those  who  have  placed  them  in  office.  Their  judgment  being 
made  conclusive,  they  may  act  with  impunity,  for  their  find- 
ings can  be  impeached  and  their  acts  invalidated  only  upon 
proof  of  actual  fraudulent  intent — a  matter  difficult  of  ascer- 
tainment and  proof  in  ordinary  circumstances  and  made 
doubly  so  through  the  great  care  taken  to  create  the  semblance 
of  a  bona-fide  transaction.  Especially  where  the  value  of  the 
property  involved  is  uncertain  and  fluctuating,  or  where  there 
can  be  no  fixed  standard  of  value  save  the  judgment  of  those 
who  deal  with  it,  with  a  possibility  of  as  many  estimates  of 
value  as  estimators,  it  is  very  difficult  to  prove  that,  even  were 
the  property  accepted  at  double  the  actual  worth,  the  over- 
valuation was  not  due  to  an  honest  mistake  in  judgment  but 
rather  to  deliberate  intent  to  commit  fraud. 

The  rule  is  well  settled  that  an  honest  mistake  in  judgment 
will  be  insufficient  to  vitiate  a  transaction,  and  that  actual 
fraud  must  be  proven,  although  fraud  may  be  presumed  as  a 
matter  of  law  in  flagrant  instances  of  gross  overvaluation. 
Just  where  the  plea  of  honest  mistake  will  be  overcome  by  a 
presumption  cannot  be  definitely  stated,  but  the  property  ac- 
cepted must  have  possessed  at  least  a  certain  tangibility  of 
value  to  support  the  plea.  A  non-patented  and  non-patentable 
idea,  for  instance,  has  been  held  to  have  no  such  value  as  to 
protect  the  issue  of  stock  in  exchange  therefor. 

Property  is  not  deemed  to  have  been  accepted  at  an  over- 
valuation on  the  mere  ground  that,  by  the  test  of  subsequent 
events,  it  is  shown  to  possess  a  value  less  than  the  face  of  the 
stock,  and  fraud  cannot  be  presumed  from  the  fact  that  prop- 
erty exchanged  for  stock  possesses  a  value  fluctuating,  un- 
certain, and  difficult  of  exact  measurement.  Inquiry  is  directed 
to  the  question  of  whether  at  the  time  of  the  directors'  de- 
termination the  property  had,  or  under  all  the  circumstances 


PAR  VALUE  AND   VALUE   OF   STOCK  6l 

could  reasonably  have  been  deemed  to  have,  a  value  equalling 
the  par  value  of  the  stock  issued. 

§  29.     (2)  Statutory  Restraints  on  Watering  Stock 

Legislation  which  seeks  to  restrain  the  practice  of  over- 
valuation of  property  should  be  so  designed  as  to  give  adequate 
protection  to  bona-fide  stockholders,  creditors,  and  the  public, 
against  those  who  would  resort  to  the  practice  for  their  own 
undue  profit.  If  corporate  enterprises  are  to  be  encouraged, 
investors  must  be  placed  in  a  position  to  be  informed  correctly 
and  authoritatively  of  all  the  facts  so  that  they  may  arrive  at 
proper  estimates  of  value.  Then,  one  who  purchases  shares  of 
stock  knowing  the  facts  surrounding  the  original  issue  and 
being  cognizant  of  the  defects  therein,  cannot  complain  later 
if  he  suffers  loss  or  is  required  to  make  up  a  deficiency  of  the 
original  investment  because  of  the  improper  organization  of 
the  corporation.  However,  where  he  cannot  know  the  facts, 
it  is  manifestly  unfair  to  make  the  bona-fide  stockholder  re- 
sponsible for  the  deficiency  in  the  original  investment,  unless 
he  is  given  the  full  assistance  of  the  law  in  attempting  re- 
covery from  those  who  profited  by  his  ignorance.  Similarly, 
creditors  are  entitled  to  full  knowledge  of  all  the  facts  affect- 
ing the  basis  of  credit  and  should  be  enabled  to  seek  remedy 
against  some  responsible  party  if  they  suffer  loss  through  the 
suppression  of  facts.  Over  and  above  the  limited  interests  of 
the  creditors,  there  is  the  wider  economic  interest  of  the  com- 
munity at "  large  in  the  maintenance  of  financial  integrity. 
Then  there  is  the  more  immediate  public  interest  which  re- 
quires of  public  service  corporations  that  only  such  charges 
and  rates  shall  be  imposed  as  will  be  fair  and  just  upon  the 
basis  of  the  capital  invested  and  necessary  to  render  the  par- 
ticular service  demanded.  Accordingly,  legislation  has  ad- 
vanced along  two  main  lines,  the  one  seeking  to  make  issues 
bona-fide  by  eliminating  personal  interest  or  bias  in  the  de- 
termination of  value  of  property  or  services  accepted  as  pay- 


62  CAPITAL    STOCKS 

ment;  the  other  seeking  to  give  pubHcity  to  all  the  details 
affecting  the  organization  of  the  corporation  and  its  financial 
transactions. 

Statutory  Restraints  in  European  Countries.  The  experi- 
ments of  some  European  countries  in  this  matter  are  inter- 
esting. The  French  law  recognizes  two  classes  of  stock- 
holders— those  paying  for  shares  in  cash  and  those  paying  in 
other  forms  of  consideration.  The  latter  are  subject  to  pro- 
visions limiting  their  possible  influence  in  the  determination  of 
value;  for  instance,  they  may  not  participate  in  any  action 
determining  the  value  of  the  property  to  be  accepted  as  pay- 
ment ;  that  value  is  to  be  determined  by  the  stockholders  who 
have  paid  cash  for  their  shares,  and  who  act  upon  the  report 
of  valuation  experts.  The  most  important  provision,  how- 
ever, is  that  which  suspends  the  negotiability  of  vendor's 
shares  for  a  period  of  two  years  after  complete  organization 
of  the  corporation,  during  those  years  making  the  present, 
intermediate,  and  original  vendor-shareholders  jointly  and 
severally  liable  for  the  balance  unpaid  upon  the  shares.  This 
is  a  measure  intended  to  restrain  promoters  from  issuing  large 
blocks  of  shares  to  themselves  for  insufficient  value  and  with 
the  sole  expectation  of  realizing  immediate  profits  by  their 
sale;  it  is  also  intended  to  protect  creditors  by  giving  them 
recourse  against  the  original  or  intermediate  holders  should 
their  present  successors  prove  irresponsible.  Even  with  these 
ingenious  provisions,  however,  it  is  said  that  the  French  law 
has  not  succeeded  in  eliminating  the  influence  of  controlling 
stockholders  in  the  determination  of  value. 

The  German  law  also  recognizes  two  classes  of  stock- 
holders and  provides  for  a  "qualified"  organization  in  instances 
where  stockholders  have  been  permitted  to  make  payment  other 
than  in  money.  It  is  sought  to  procure  the  elimination  of 
personal  interest  by  requiring  that  the  necessary  certificate  of 
proper  organization  to  be  made  by  the  organizers  shall,  in  the 
case  of  a   "quahfied"  organization,   be  also  certified  to  by 


PAR  VALUE  AND  VALUE  OF  STOCK 


63 


auditors  appointed  by  the  official  board  of  trade  of  the  district 
or  by  the  court ;  the  aim  here  is  that  of  assuring  a  disinterested 
investigation.  Persons  paying  for  their  stock  other  than  in 
money  are  regarded  as,  and  subjected  to,  the  special  responsi- 
bihties  imposed  upon  organizers.  In  some  ways  the  provisions 
regarding  the  duties  and  responsibihties  of  stockholders  of  the 
two  classes  resemble  the  provisions  of  the  French  law;  the 
German  law,  however,  lays  somewhat  greater  emphasis  upon 
publicity.  Among  the  papers  necessary  to  be  filed  to  complete 
the  proper  organization  of  the  corporation  must  be  Included  a 
declaration  setting  forth  all  of  the  circumstances  surrounding 
the  acceptance  of  a  consideration  other  than  money  for  the 
stock.  The  main  criticism  which  has  been  levelled  at  the  Ger- 
man law  in  these  respects  is  that  its  elaborateness  operates 
to  bury  necessary  facts  rather  than  to  expose  them,  thus  de- 
feating the  very  ends  it  is  intended  to  serve. 

Publicity  is  the  basis  of  the  English  legislation  in  this 
respect;  it  seeks  to  protect  investors  and  creditors  by  putting 
in  their  possession  a  correct  and  trustworthy  statement  of  all 
the  incidents  of  the  proposed  issue,  and  then  leaves  them  free 
to  act  according  to  their  own  judgment  and  prudence.  The 
Companies  Act  of  1900  requires  the  prospectus,  if  one  is  to  be 
issued,  and  if  not,  then  the  statement  in  lieu  thereof,  to  give 
the  necessary  details  of  organizers,  directors,  classification  of 
stock,  etc.,  and  in  addition  to  name  all  vendors  of  the  property 
which  the  company  intends  to  accjuire  in  exchange  for  shares 
or  debentures;  it  must  also  describe  specifically  the  amount 
paid  for  good-will,  for  underwriting,  and  for  promotion,  the 
estimated  amount  of  preliminary  expenses,  and  the  nature  and 
extent  of  the  interest  of  every  director  in  the  promotion  of 
the  company  or  in  the  property  proposed  to  be  acquired. 
Every  director,  promoter,  or  other  person  authorizing  state- 
ments contained  in  the  prospectus  is  directly  liable  to  persons 
sustaining  loss  or  damage  by  reason  of  the  falsity  of  those 
statements,  unless,   of  course,  the  person  charged  with  the 


64  CAPITAL   STOCKS 

falsity  can  prove  that  he  himself  believed  the  statement  to  be 
true  at  the  time  it  was  made  and  up  to  the  time  of  the  issue  of 
the  shares  or  debentures,  and  that  there  were  reasonable 
grounds  to  support  the  belief. 

§30.     (3)  Effect  of  Watering  Stock  of  Public  Service  Cor- 
porations 

In  the  case  of  public  service  corporations  the  effect  of 
"water"  in  the  stock  upon  the  rates  and  charges  of  the  com- 
pany for  service  has  been  the  most  emphasized.  The  stock- 
holder has  invested  his  capital  in  the  corporate  enterprise  where 
he  expects  it  to  be  income-producing.  If  the  exigencies  of  the 
corporation  cause  an  impairment  of  the  capital,  he  is  quite 
unwilling  to  dissociate  his  intention  in  making  the  investment 
from  the  fact  of  its  present  status;  and  especially  in  the  case 
of  public  service  corporations,  where  the  fixed  capital  required 
is  so  large,  he  has  sought  to  maintain  a  more  or  less  artificial 
equality  between  capital  and  capital  stock.  Sometimes  in  pro- 
posing rates  and  charges  for  service  and  commodities,  he  has 
put  forward  the  amount  of  capital  stock  for  a  basis,  rather  than 
the  actual  capital  in  service.  His  unwillingness  to  dissociate 
intention  from  fact  has  been  favored  by  the  very  general  con- 
fusion between  the  par  value  of  stock  and  its  real  value  as 
represented  by  the  net  corporate  assets.  The  public,  for  too 
long  a  period,  has  accepted  the  par  value  of  stock  as  the 
measure  of  corporate  investment. 

"The  harmfulness  of  excessive  issues  of  the  capital  stock  of 
corporations  serving  the  public  arises  from  the  fact  that  stock 
of  a  given  face  value  has  not  behind  it  property  equal  in  actual 
value  to  the  face  value  of  the  stock.  The  result  is  that  the 
owners  of  the  stock  naturally  assume  the  value  of  the  corporate 
assets  to  be  at  least  equal  to  the  face  value  of  the  stock,  demand 
an  adequate  return  upon  the  same,  and  in  the  effort  to  secure 
such  return  both  demand  excessive  prices  for  services  ren- 
dered and  impair  and  cheapen  the  service. 


PAR  VALUE  AND  VALUE  OF  STOCK       65 

"The  stock,  in  the  natural  course  of  business,  falls  into  the 
hands  of  bona-fide  purchasers,  who  buy  the  same  upon  the 
assumption  that  it  is  issued  dollar  for  dollar  of  value.  Any 
effort  to  reduce  prices  for  services  rendered  after  stocks  have 
fallen  into  the  hands  of  such  holders  is  fought,  as  tending  to 
impair  the  value  of  existing  securities  and  unsettling  the  basis 
of  all  corporate  transactions.  This  last  trouble  arises  from 
regarding  the  share  of  stock  as  representing  value  to  an 
amount  equal  to  its  face  value.  Were  all  stock  issues  for  full 
value,  this  might  be  true  for  a  brief  interval,  but  in  the  practi- 
cal course  of  business  such  equality  rarely  exists."  ^ 

The  Prospectus  Act  of  England  is  perhaps  most  often  re- 
ferred to  in  this  country  as  a  desirable  modification  of  our  own 
laws.  There  have  been  many  who  have  contended,  however, 
that  publicity  is  not  enough ;  that  its  aim  is  merely  the  protec- 
tion of  the  investor,  and  that  it  affords  no  remedy  for  the  evil 
results  of  overcapitalization  as  affecting  the  public.  Even  as 
a  restraint  upon  the  propensities  of  promoters,  publicity  has 
been  said  to  be  inadequate,  "Publicity  is  good,"  said  the  late 
Commissioner  Clements,  ^  "but  publicity  is  not  entirely  ade- 
quate for  those  who  defy  public  opinion  as  well  as  good 
morals,  and  there  are  some  of  them  large  enough,  and  ex- 
perienced in  it  enough,  so  that  publicity  is  not  going  to  restrain 
them  as  it  should." 

Undoubtedly  the  most  satisfactory  legislation  is  to  be  found 
in  the  enactment  of  public  service  commission  laws.  Under 
these  laws  the  corporations  amenable  to  them  are  prohibited 
from  issuing  capital  stock  or  bonds  without  first  securing  au- 
thorization from  the  proper  commission.  That  authorization 
will  be  granted  only  after  full  investigation  of  the  purposes  to 
which  the  issue  is  to  be  applied,  and  the  proper  application  of 
the  proceeds  will  be  fixed  in  the  order  of  authorization.    In  this 


'  New  York  Central  &  Hudson  River  R.  R.  Co.  and  Rochester  and  Eastern  Rapid 
Ry.  Co.,  1  P.  S.  C.  Rep.,  2nd  D.,  N.  Y.  254  (314-315)- 

'  Of  Interstate  Commerce  Commission,  speaking  before  the  convention  of  Railroad 
Commissioners  in  1913. 


(^  CAPITAL   STOCKS 

manner  not  only  is  the  final  determination  of  the  value  at 
which  property  is  to  be  acquired,  or  the  amount  of  compensa- 
tion to  be  paid  to  promoters  and  others  for  their  services, 
placed  under  the  scrutiny  of  an  independent  board,  but  also  full 
publicity  is  assured,  thus  affording  ample  protection  alike  to  the 
prospective  stockholders,  creditors,  and  the  general  public. 
The  extent  to  which  that  protection  will  be  adequate  and 
effective  depends  very  much,  of  course,  upon  the  measure  of 
discretion  and  wisdom  exercised  by  the  commissioners  in  the 
discharge  of  their  duties,  and  upon  their  honesty  and  integrity. 

§31.     (4)  Aspects  of  Stock- Watering  Sometimes  Considered 
Defensible 

Concerning  much  of  the  legislation  in  the  United  States  it 
is  admitted  that  in  many  instances  the  administration  of  the 
law  purposely  has  been  made  lax.  It  has  often  been  felt  that 
the  strictness  of  the  law  has  interfered  unfortunately  with  the 
building  up  of  railroads  or  the  setting  up  of  other  enterprises 
in  new  communities  or  under  especially  adverse  circumstances. 
"The  very  rigidity  of  the  statute  has  caused  the  public  to  be 
negligent  in  its  enforcement.  In  some  cases  the  laws  have  been 
so  drawn  as  actually  to  invite  evasion,  by  specifically  leaving  it 
to  the  judgment  of  the  directors  to  decide  what  constituted  an 
adequate  consideration  for  the  shares.  The  companies  have 
thus  been  enabled  to  represent  that  their  stock  was  fully  paid, 
when  this  was  not  the  case."  ^ 

During  a  period  of  reconstruction  such  as  that  which  fol- 
lowed the  Civil  War,  or  that  which  will  follow  the  present 
Great  War,  investments  in  constructive  enterprises  will  be  the 
greatest  of  public  needs ;  the  same  is  true  of  communities  where 
organized  exploitation  is  almost  essential  to  development.  In 
order  to  commit  himself  to  such  enterprises  the  investor  has 
demanded  and  will  demand  the  probability  of  speculative 
profits  to  supplement  the  conservative  returns  which  are  fairly 

'  Report  of  Railroad  Securities  Commission. 


PAR  VALUE  AND  VALUE  OF  STOCK 


67 


well  assured.  Public  policy  may  wisely  consider  the  present 
benefit  as  being  worth  the  reward  asked,  and  will  permit  over- 
capitalization in  the  expectation  that  the  future  prosperity  of 
the  company  will  absorb  the  "water."  Is  this  anything  more 
or  less  than  a  bargain  by  which  the  community  agrees  to  share 
with  the  corporation  the  benefit  which  the  corporate  enterprise 
brings  to  it?  Under  a  great  many  circumstances,  may  not 
such  an  agreement  be  no  more  than  fair?  True  enough,  a 
better  method  could  be  devised,  but  if  the  agreement  is  of 
mutual  benefit,  the  burden  of  devising  the  method  is  equally 
apportioned  between  the  public  and  the  corporation. 

The  United  States  Steel  Corporation  afifords  a  striking  ex- 
ample of  how  the  assurance  of  future  prosperity  may  warrant 
overvaluation  in  the  organization  of  a  corporation.  When  this 
company  was  first  organized  its  alleged  overcapitalization  was 
loudly  and  vigorously  condemned,  and  no  one  could  avoid 
hearing  of  the  condemnation  and  learning  of  the  alleged 
"water"  in  the  stock;  now  some  of  those  who  predicted  the 
most  disastrous  results  are  most  anxious  to  buy  the  stock  at 
well  above  par. 

Undoubtedly  there  are  instances  where  "stock-watering," 
i.e.,  the  issue  of  shares  in  exchange  for  a  consideration  ap- 
parently less  than  par,  should  not  be  condemned  without  very 
careful  investigation.  There  are  instances  where,  for  one 
reason  or  another,  it  becomes  proper  for  the  issuing  corpora- 
tion to  place  a  constructive  value  upon  the  property  to  be 
accepted  as  payment.  For  example,  the  shares  of  stock  or 
other  securities  of  a  bankrupt  corporation  are  admittedly  worth 
little,  if  anything;  yet  upon  reorganization  of  its  affairs  the 
new  corporation  may  issue  its  capital  stock  in  exchange  for  the 
capital  stock  of  the  bankrupt  corporation  at  par  or  at  some 
figure  unc|uestionably  representing  more  than  the  present 
worth  of  the  assets,  and  this  transaction  may  be  one  of  much 
merit  in  affording  a  basis  for  the  continuance  of  operations 
necessary  to  the  public  welfare.     Again,  where  the  stock  of  a 


68  CAPITAL   STOCKS 

going  concern  is  taken  over  by  a  merging  company  in  exchange 
for  its  own  capital  stock  at  a  value  exceeding  the  par  or  present 
value  of  the  shares  of  the  merged  corporation,  the  transaction 
may  be  eminently  fair  if  the  merger  is  economically  necessary. 
In  such  cases  the  deficiency  is  usually  taken  up  on  the  books  by 
the  assignment  of  some  "intangible"  value  to  the  property 
taken  over.    Public  policy  itself  may  thus  justify  it. 

In  connection  with  modern  legislation  relating  to  this  sub- 
ject the  opinion  of  one  who  was  responsible  for  much  of  the 
Wisconsin  Public  Utilities  Law  is  of  more  than  passing  inter- 
est. Mr.  Roemer,  then  Chairman  of  the  Wisconsin  Commis- 
sion, in  a  letter  to  the  National  Civic  Federation  *  expresses  his 
convictions  as  follows: 

The  more  I  study  and  reflect  upon  the  regulation  of  stock 
and  bond  issues  by  public  authorities,  the  more  I  am  inclined 
to  the  opinion  that  my  views  when  I  re-drafted  the  Wiscon- 
sin stock  and  bond  law  were  unduly  influenced  by  the  pre- 
vailing prejudice  against  the  sin  of  watered  stock.  In  pro- 
viding a  remedy  for  this  admitted  evil,  it  is  a  question  in 
my  mind  whether  other  evils  are  not  already  resulting  from 
the  scheme  of  supervision  of  stock  and  bond  issues  provided 
in  our  law,  and  in  substance  incorporated  in  your  model  bill, 
which  will  tend  to  defeat  in  a  great  measure  the  purpose  of 
the  act,  and  will  also  likely  embarrass,  in  certain  instances, 
the  commission  in  performing  its  primary  function  of  super- 
vising and  regulating  the  rates  and  services  of  public  service 
corporations. 

As  I  view  the  matter,  the  regulation  of  the  issues  of  cor- 
porate securities  is  and  must  be  for  the  benefit  of  the  in- 
vestor  In  authorizing  the  issuance  of  securities  and 

directing  the  investment  of  the  proceeds  thereof,  the  state  is 
assuming  a  responsibility  which,  in  the  very  nature  of  things, 
it  ought  not  to  do.  The  state  cannot  direct  the  management  of 
the  corporation,  and  therefore,  should  not  undertake  the  re- 
sponsibility of  authorizing  the  issuance  of  securities  and  direct- 
ing the  investment  of  their  proceeds.    By  so  doing  it  is  likely  to 


*  Reprinted  in  proceedings  of  1913  convention  of  Association  of  Railroad  Coromis^ 
sioners,  pages  181-182, 


PAR  VALUE  AND  VALUE  OF  STOCK 


69 


cause  certain  investors  who  purchase  such  securities  as  an 
investment  without  knowing  anything  of  the  management  of 
the  corporation  or  the  possibiHties  of  the  enterprise,  to  rely 
upon  the  state  sanction  of  the  issues.  These  are  the  investors 
who  need  protection,  and  who,  I  am  apprehensive,  will  often 
be  the  victims  of  investments  in  ill-advised  and  mismanaged 
public  service  corporations  whose  securities  have  been  au- 
thorized by  state  commissions.  The  business  man  who  deals 
in  such  securities  needs  no  protection.  In  my  judgment,  the 
responsibility  of  issuing  corporate  securities  and  applying 
the  proceeds  of  same  to  corporate  purposes  should  rest  with 
the  management  of  the  corporation,  subject,  of  course,  to 

general  statutory  restrictions  and  limitations 

As  a  result  of  the  experience  under  the  Wisconsin  law, 
I  have  come  to  the  conclusion  that  the  English  Companies 
Act  is  a  much  wiser  measure  for  the  regulation  of  the  issues 
of  corporate  securities  than  any  other  laws  or  proposed 
measures  that  have  come  to  my  attention  in  this  country.  If 
I  were  to  draft  the  law  again,  I  should  be  guided  by  the 
fundamental  principles  of  that  Act. 

Apparently  the  conviction  that  under  special  circumstances 
the  issue  of  stock  for  a  consideration  admittedly  of  less  value 
than  par  is  allowable,  has  been  growing-  in  the  minds  of  those 
active  in  the  drafting  of  the  more  recent  statutes,  for  there 
have  been  enacted  a  number  of  statutes  permitting  the  issue  of 
stock  at  a  discount.  In  at  least  one  instance  the  possible  justi- 
fication of  overcapitalization  is  impliedly  admitted.  This  is  in 
the  Texas  law  which  provides  that  "no  bonds  or  other  in- 
debtedness shall  be  increased,  issued  or  executed,  by  any  au- 
thority whatsoever,  and  secured  by  lien  or  mortgage  on  any 
railroad,  or  the  franchises  or  property  appurtenant  or  belong- 
ing thereto,  over  or  above  the  reasonable  value  of  said  railroad 
property,  provided,  that  in  case  of  emergency,  on  conclusive 
proof  shown  by  the  company  to  the  Railroad  Commission  that 
public  interests  or  the  preservation  of  the  property  demand  it, 
the  said  Commission  7nay  permit  said  bonds,  together  imth  the 
stock  in  the  aggregate,  to  be  executed  to  an  amount  not  more 
than  fifty  per  cent  over  the  value  of  said  property." 


70 


CAPITAL    STOCKS 


§  32.     Stock  Issued  at  Discount 

If  stock  issued  at  a  discount  is  to  be  given  a  definition 
carrying  with  it  an  actual  differentiation  from  "watered"  stock, 
it  may  be  said  to  consist  of  stock  issued  under  lawful  authority 
for  an  original  consideration  of  fixed  or  admitted  value  less 
than  par,  but  with  all  the  rights  and  privileges  of  full-paid 
stock.  It  is  to  be  distinguished  from  watered  stock  merely  in 
degree  and  motive,  in  that  the  discount  is  supposed  to  be  rea- 
sonable and  the  issue  below  par  justifiable  in  view  of  the  cir- 
cumstances surrounding  the  issue.  Watered  stock  is  supposed 
to  be  in  contravention  of  the  law,  while  discounted  stock  is  in 
accord  with  the  law. 

The  public  utility  laws  recently  passed  by  some  states  have 
modified  the  rule  as  to  issue  of  stock  at  less  than  par,  so  as  to 
permit  the  issue  of  stock  at  a  discount.  The  Michigan  law 
imposes  no  limitations  and  leaves  it  to  the  orders  of  the  Com- 
mission to  determine  the  price  of  issue ;  the  Ohio  statute  makes 
it  incumbent  upon  the  Commission  to  determine  the  terms  of 
issue;  the  Massachusetts  statute  provides:  "The  decision  of  the 
Commission  as  to  the  amount  of  stock  which  is  reasonably 
necessary  for  the  purpose  for  which  such  stock  is  proposed  to 
be  issued  shall  be  based  upon  the  price  at  which  such  stock  is 
to  b*e  issued  and  the  Commission  shall  refuse  to  approve  any 
particular  issue  of  stock  if,  in  its  opinion,  the  price  at  which  it 
is  proposed  to  be  issued  is  so  low  as  to  be  inconsistent  with  the 
public  interest." 

Probably  Massachusetts  has  experimented  more  than  any 
other  state  with  statutes  regulating  the  price  of  issue,  having 
tried  out  a  number  of  expedients  since  as  early  as  1891.  All 
issues  at  less  than  par  were  prohibited  at  first;  then,  after  a  few 
years  the  experiment  of  public  auction  sales  was  adopted  from 
the  English  act  for  gas  companies.  Then  came  the  anti-stock 
watering  laws  of  1894,  fixing  the  price  of  issue  to  correspond 
with  the  market  value,  as  ascertained  by  the  Railroad  Commis- 
sion.    For  a  number  of  years,  during  which  generally  pros- 


PAR  VALUE  AND  VALUE  OF  STOCK 


71 


perous  conditions  pushed  market  prices  upward,  this  method 
worked  well ;  under  it  the  Boston  and  Maine  Railroad  Com- 
pany was  able  to  realize  as  high  as  $190  a  share.  The  1903 
panic  and  the  subsequent  depression  proved  the  law  to  be  un- 
duly drastic  and  in  1908  the  law  was  amended  again  to  permit 
issue  at  a  price,  not  less  than  par,  to  be  determined  by  the 
stockholders  and  approved  by  the  Commission.  The  present 
law  as  above  quoted  was  an  incident  of  the  creation  of  a  public 
service  commission  endowed  with  great  regulative  control  over 
matters  of  finance. 

A  bill  introduced  into  Congress  ( 1913)  to  vest  in  the  Inter- 
state Commerce  Commission  control  over  the  capitalization  of 
interstate  corporations  (but  which  failed  of  passage)  pro- 
vided: "Any  company  which  has  been  in  continuous  existence 
for  more  than  two  years  may  sell  additional  shares  at  a  dis- 
count, if  necessary  to  procure  their  sale;  but  no  shares  shall 
thus  be  sold  at  a  discount  without  the  previous  express  ap- 
proval of  the  Interstate  Commerce  Commission  as  necessary 
and  in  the  public  interest." 

The  bill  also  provided:  "It  shall  be  lawful  for  such  corpora- 
tion to  pay  a  commission  to  any  person,  if  necessary  as  a  con- 
sideration to  his  subscribing  or  agreeing  to  subscribe  for  any 
shares  or  procuring  or  agreeing  to  procure  subscriptions."  It 
it  rather  unusual  to  insert  a  provision  such  as  the  last  into  the 
statute,  as  ordinarily  the  right  of  a  corporation  to  pay  a  com- 
mission for  the  sale  of  stock  out  of  the  proceeds  of  the  sale  is 
not  questioned.  In  fact,  that  is  the  basis  of  the  business  of 
underwriting  issues  of  securities. 

It  needs  to  be  emphasized  that  unless  the  issue  of  stock  at 
a  discount  is  expressly  permitted,  the  purchaser  of  shares  at  a 
discount  will,  as  a  matter  of  law,  be  liable  for  the  amount  of 
the  discount  to  the  corporation  and  its  creditors. 

There  would  be  no  object  in  marketing  an  original  issue  of 
stock  at  a  discount,  and  the  fact  that  it  has  been  so  marketed 
must  be  ascribed  to  the  psychology  of  the  investor.     In  the 


72 


CAPITAL   STOCKS 


case  of  bonds  the  discount  earned  by  the  purchaser  operates  to 
increase  the  actual  return  on  the  investment,  for  upon  maturity 
the  bond  will  be  paid  at  its  par  value.  But  shares  of  stock  do 
not  mature ;  at  no  time  during  the  life  of  the  corporation,  save 
for  a  brief  instant  in  the  earliest  stages,  will  the  value  of  the 
shares  bear  any  relation  to  par  value.  The  market  value  which 
the  stockholder  can  hope  to  realize  in  normal  conditions  will 
be  based  upon  the  value  of  the  property  and  its  earning 
capacity — matters  which  will  presumably  bear  no  definite  rela- 
tion to  the  actual  amount  of  the  stockholders'  original  contri- 
bution. 

There  have  been  many  instances  where  the  financing  of  a 
corporate  enterprise  has  been  especially  difficult,  so  much  so 
that  success  of  the  project  has  necessitated  an  appeal  to  the 
trading  instinct  of  the  intending  purchaser  by  an  off^er  to  sell 
stock  to  him  below  par.  Consciously  or  unconsciously,  the 
purchaser  relies  upon  general  acceptance  of  the  par  value  as  the 
measure  of  investment  in  the  corporate  capital,  and  therefore 
expects  to  be  able  to  realize  appreciation  on  his  holdings 
through  either  one  of  two  causes.  Sometimes  the  stockholder 
hopes  that  he  will  be  able  to  sell  at  a  higher  price  than  he  paid, 
even  though  that  price  be  less  than  the  par,  to  another  who, 
misled  by  the  par  value  expressed,  will  think  he  is  getting  a 
bargain;  other  stockholders  believe  that  the  company  will  be 
permitted  to  earn  on  the  basis  of  the  par  of  stock  rather  than 
the  capital  invested,  so  that  extra  earnings  will  in  time  make 
up  the  difference  and  raise  the  value  to  par.  It  will  sometimes 
be  said  that  the  issue  at  discount  indicates  the  measure  of  risk 
which  the  purchaser  is  called  upon  to  assume,  and  for  which  he 
demands  extra  compensation.  The  practice  of  stating  divi- 
dends at  a  percentage  of  par,  rather  than  a  given  amount  per 
share,  is  in  a  way  responsible  for  this  idea;  the  truth  of  the 
matter,  nevertheless,  will  still  be  as  stated  above. 

A  corporation  seeking  additional  capital  may  find  itself 
confronted  with  the  fact  that  its  outstanding  stock  has  acquired 


PAR  VALUE  AND  VALUE  OF  STOCK       73 

a  definite  market  value,  which  necessarily  limits  the  price  at 
which  any  new  issue  of  the  same  class  of  stock  could  be 
marketed.  If  the  market  value  is  below  par,  obviously  the 
issue  of  new  stock  at  par  is  out  of  the  question.  In  such  cir- 
cumstances corporations  have  been  compelled  to  borrow  the 
needed  additional  capital,  often  at  high  rates  of  interest,  while 
they  would  have  preferred,  and  prudence  would  have  dictated, 
that  no  increased  burden  of  debt  be  assumed.  The  issue  of 
stock  at  a  discount  here  becomes  a  measure  of  conservative  and 
prudent  financing  and  should  be  allowed.  The  only  objection 
is  that  since  the  new  stock  will  be  taken  up  on  the  books  at  par 
there  will  be  created  an  apparent  deficit,  ^  which  the  corpora- 
tion may  seek  to  make  good  by  exacting  a  higher  rate  for  its 
services — a  thought  which  is  disquieting  to  the  peace  of  the 
public  mind.  It  may,  however,  be  but  a  very  simple  matter  of 
justice  that  the  corporation  should  be  permitted  to  make  good 
the  deficit  out  of  higher  charges.  If  the  initial  issues  had  been 
made  at  par,  the  fact  that  market  prices  fell  below  par  may 
very  correctly  indicate  that  the  corporation  was  not  collecting 
an  adequate  rate,  and  when  its  error  is  brought  home  to  it,  the 
corporation  should  be  allowed  to  raise  its  rates  and  compel  the 
public  to  make  up  the  deficiency.  Rate-making  used  to  be  a 
great  experiment;  even  now  it  is  anything  but  a  science,  and 
rates  against  the  corporation's  interest  have  been  almost  as 
frequent  as  those  favoring  it  unduly.  The  effect  of  former 
abuses  hinders  ideal  practice  as  yet. 

§  33.     Stock  Issued  at  Premium 

There  never  has  been  any  objection  raised  to  the  issue  of 
shares  at  a  premium,  that  is,  for  a  consideration  greater  than 
its  par  value.  Theoretically  this  is  just  as  wrong  as  issue  at 
a  discount,  but  it  has  lacked  the  suspicion  of  being  a  danger- 
ous expedient.    Corporations  which  could  command  premiums 


°  Assuming  that  the  amount  of  the  discount  is  not  set  up  as  a  contra  entry  against 
the  par  value  of  stock  but  is  charged  directly  to  Profit  and  Loss  account. 


74 


CAPITAL   STOCKS 


upon  their  shares  have  been  considered  fortunate,  although 
that  has  not  been  an  unusual  situation  by  any  means,  as  will 
be  readily  seen  by  reference  to  the  balance  sheets  of  some  of 
the  leading  railroads.  Usually,  of  course,  the  premiums  are 
realized  upon  issues  of  additional  stock,  placed  upon  the  market 
to  raise  new  capital  after  the  credit  of  the  corporation  has 
become  established.  The  amount  of  the  premium  usually  bears 
some  relation  to  the  dividends  which  have  been  paid  by  the 
company,  the  continuance  of  which  is  expected  by  the  payer 
of  the  premium. 

The  generally  accepted  theory  is  that  the  premiums  repre- 
sent a  payment  by  the  purchasers  of  the  stock  for  the  privilege 
of  acquiring  a  new  or  added  interest.  If  this  theory  be  given 
its  logical  effect,  the  premium  will  accrue  to  the  favor  of  the 
existing  stockholders,  among  whom  it  could  be  distributed  as 
a  special  dividend,  and  there  will  be  no  reason  for  carrying 
the  amount  as  a  permanent  reserve.  The  reason  why  a 
premium  is  paid  is  either  that  the  value  of  the  proportionate 
interest  of  the  shares  in  the  corporate  assets  exceeds  their  par 
value,  or  else  that  the  assurance  of  earnings  is  such  as  to 
assign  a  high  investment  value  to  the  shares.  In  the  final 
analysis  the  last  reason  becomes  merged  in  the  first,  for  in 
most  cases  the  value  of  the  corporate  assets  as  a  whole  is  predi- 
cated upon  earning  power.  Under  these  circumstances  the 
premium  is  collected  on  the  new  shares  to  equalize  the  inter- 
ests of  the  old  and  new  stockholders.  Let  us  assume  that  the 
old  stockholders  paid  par,  and  thereafter  put  back  enough 
earnings  in  the  plant  to  give  the  stock  a  certain  value  above 
par;  the  new  stockholders  pay  par  also,  and  in  addition  an 
amount  approximating  the  amount  of  earnings  not  taken  out 
by  the  old  stockholders.  The  two  sets  of  stockholders  are 
thus  put  upon  an  equal  footing;  they  could  then  turn  around 
and  divide  the  corporate  assets  above  the  par  of  the  total  capi- 
tal stock  with  absolute  equity  to  both  the  old  and  the  new 
stockholders. 


PAR  VALUE  AND  VALUE  OF  STOCK       75 

§  34.     Accounting  for  Issues  of  Stock  at  Discount  or  Premium 

Where  capital  stock  is  issued  at  a  premium  the  uniform 
rule  is  that  the  amount  of  the  premium  shall  be  set  upon  the 
company's  books  under  a  proper  designation,  e.g.,  "Premiums 
Realized  on  Capital  Stock,"  to  remain  there  so  long  as  the 
stock  in  connection  with  which  it  was  realized  remains  out- 
standing. The  account  to  which  the  premium  is  credited  is 
customarily  grouped  with  permanent  reserve  accounts,  but  will 
appear  upon  the  balance  sheet  as  a  corporate  responsibility  of 
the  same  nature  as  the  outstanding  stock.  The  correctness  of 
this  method  has  generally  been  accepted  without  question,  but 
if  the  reason  for  the  collection  of  the  premiums  is  that  oi 
equalizing  the  interests  of  the  new  stockholders  with  those 
of  the  old,  should  not  the  additional  payment  by  the  new 
stockholders  be  carried  to  the  same  account  which  registers 
the  value-over-par  interest  of  the  old,  to  wit,  the  Corporate 
Surplus  or  Deficit  account? 

There  is  no  actual  loss  suffered  by  a  corporation  issuing 
its  stock  at  a  discount;  if  the  capital  stock  were  taken  upon 
the  books  only  at  the  amount  of  its  actual  proceeds,  no  ac- 
counting for  the  discount  would  be  necessary.  But  capital 
stock  is  taken  up  and  will  appear  on  the  liabilities  side  of  the 
balance  sheet  at  its  par  value  which,  being  greater  than  the 
proceeds  which  will  be  mingled  with  the  assets,  will  produce 
an  apparent  loss.  It  is  necessary  that  this  amount  be  not  con- 
fused with  any  others  representing  actual  assets  or  actual 
losses  incurred  in  operation.  It  will  be  set  up  as  a  deferred 
debit  by  being  charged,  under  the  rules  of  the  Interstate  Com- 
merce Commission,  to  an  account  entitled  "Unextinguished 
Discount  on  Capital  Stock,"  in  accordance  with  these  instruc- 
tions : 

"If  the  nature  of  the  balances  in  the  Discount  and  Premi- 
ums accounts  for  all  classes  of  capital  stock  sold  is  a  debit 
balance,  the  amount  should  be  stated  in  this  account.  This 
balance    should   be   carried   on   the   balance    sheet   until    ex- 


76  CAPITAL   STOCKS 

tinguished  by  premiums  realized  on  subsequent  sales  of  stock, 
by  assessments  levied  on  the  stockholders,  by  appropriations 
of  income  or  free  surplus  for  the  purpose,  or  by  retiring  the 
stock.  When  any  stock  is  retired,  the  proper  Discount  and 
Premiums  account  should  be  adjusted  by  crediting  to  it  an 
amount  equal  to  the  unextinguished  discount  on  such  stock." 

The  propriety  of  applying  premiums  on  subsequent  issues 
of  stock  to  offset  the  discount  on  previous  issues  is  open  to 
question;  if  premiums  can  be  thus  written  off,  why  could  they 
not  with  equal  propriety  be  written  off  by  being  credited 
directly  to  the  Profit  and  Loss  account? 

Until  recently  where  stock  was  issued  at  a  discount,  the 
practice  has  been  to  debit  it  to  "Cost  of  Plant."  Similarly  for 
commissions.  It  is  still  permitted  under  official  classifications 
to  charge  to  capital  accounts  the  commissions  paid  for  the 
issue  of  stock.  Commissions  paid  by  English  companies  for 
the  sale  of  their  shares  "or  so  much  thereof  as  has  not  been 
written  off,  shall  be  stated  in  every  balance  sheet  of  the  com- 
pany until  the  whole  amount  thereof  has  been  written  off." 

§35.     Par  Value  in  Relation  to  Actual  Value 

The  very  full  discussion  in  the  foregoing  pages  has  suffi- 
ciently indicated  the  disparity  which  is  bound  to  exist  be- 
tween the  par  value  of  the  shares  and  the  real  value  of  the 
proportionate  interest  in  the  net  corporate  assets  which  they 
represent.  If  the  value  of  all  the  property,  claims,  and  in- 
terest owned  by  the  corporation  be  listed  and  totaled,  and 
from  the  total  there  be  deducted  the  amount  of  debts  and 
obligations  owed,  the  remainder  is  the  value  of  the  proprietor- 
ship of  the  corporation,  the  value  of  the  equity,  the  net  cor- 
porate assets,  or  whatever  one  chooses  to  name  it.  That  re- 
mainder is  the  capital  stock,  and  divided  by  the  number  of 
shares,  the  quotient  is  the  value  of  the  shares.  If  there  is  no 
remainder,  there  is  no  equity,  no  proprietorship,  and  therefore 
no  capital  stock. 


PAR  VALUE  AND  VALUE  OF  STOCK 


n 


When  the  method  is  so  simple,  why  has  it  been  so  hard  for 
all  interested  parties  to  know  the  actual  value  of  stock,  so  as 
to  place  no  reliance  upon  a  presumption  that  a  value  once  fixed 
by  the  payment  of  a  certain  amount  for  a  share  continues  to 
exist? 

The  first  and  greatest  difficulty  is  that  although  it  is  easy 
to  speak  of  the  value  of  corporate  assets,  it  is  very  difficult 
to  substitute  dollars  and  cents  in  place  of  the  word  "value," 
The  attempts  to  determine  and  record  actual  values  of  the 
properties  owned  have  caused  considerable  dispute  heretofore; 
in  many  cases  the  attempt  was  an  honest  one,  in  other  cases 
it  was  dishonest  in  purpose  and  execution.  The  condemnation 
justly  leveled  at  the  latter  has  unfortunately  hit  the  former 
also,  and  in  the  recent  regulation  of  accounting  of  public 
service  corporations  there  has  been  total  abandonment  of  the 
attempt  to  determine  and  record  values  so  far  as  the  bulk  of 
the  capital  is  concerned.  The  prescribed  rules  now  are  that 
cost  shall  be  the  figure  recorded  and  maintained  upon  the 
books.  The  method  above  described  thus  becomes  inapplicable, 
because  the  figure  from  which  debts  and  obligations  are  de- 
ducted to  arrive  at  proprietorship  does  not  include  the  value 
of  the  properties  owned ;  knowledge  of  facts  other  than  those 
appearing  upon  the  statement  must  be  brought  to  bear  upon  a 
determination  of  real  values  of  capital  stock.  These  problems 
of  accounting  are  more  fully  discussed  in  connection  with  the 
determination  of  surplus  available  for  dividend  payments 
(see  Chapter  VII). 

The  second  difficulty  has  been  purely  an  accounting  one, 
an  incident  of  it  being  the  division  of  the  figure  of  proprietor- 
ship between  one  account  which  has  recorded  the  par  value 
of  stock  and  another  or  others  which  have  recorded  the  excess 
or  deficit  of  proprietorship  from  the  par  value  of  stock.  The 
indefiniteness  of  accounting  terms,  to  say  nothing  of  the  de- 
liberate choice  of  misrepresentative  ones,  has  been  another  in- 
cident.    Considerable  improvement  may  be  expected  in  this 


^8  CAPITAL   STOCKS 

respect  from  the  attempts  to  introduce  uniformity  of  terms 
and  practice  by  the  promulgation  of  official  accounting  classi- 
fications. It  is  to  be  sincerely  hoped,  however,  that  those  re- 
sponsible for  these  official  classifications  will  not  forget  that 
the  determination  of  the  real  value  of  proprietorship  was  the 
primary  purpose  and  continues  to  be  an  important  purpose  of 
all  scientific  accounting. 

The  third  difficulty  has  been  the  lack  of  publicity.  Stock- 
holders and  other  interested  parties  have  seldom  been  able  to 
gain  access  to  balance  sheet  and  operating  statements  when 
it  was  necessary,  and  often  such  statements  as  were  made 
public  did  not  carry  the  stamp  of  authority.  Recent  legisla- 
tion in  this  country  has  made  a  great  deal  of  publicity  possible 
and  the  results  of  this  policy  have  proved  most  beneficial. 

§36.    Issue  of  Shares  Without  Par  Value 

There  can  be  no  question  that  the  confusion  between  par 
value  and  real  value  has  been  the  source  of  a  great  deal  of 
mischief,  and  that  on  many  occasions  the  confusion  has  been 
deliberately  caused  to  facilitate  the  exploitation  of  unmeri- 
torious  schemes.  There  are  many  people,  some  of  them  quite 
sensible  and  prudent  in  other  matters,  who  are  eager  to  give 
good  money  for  a  certificate  marked  "Par  Value  $100"  if  it  is 
sold  at  $90  or  some  other  figure  below  par,  and  corfsider  it  a 
bargain  without  inquiring  into  the  real  value  at  all,  which  may 
be  nil.  The  amount  of  worthless  stock  which  has  been  sold  by 
this  very  simple  device  cannot  be  estimated,  and  it  still  con- 
tinues to  run  into  large  figures  each  year. 

To  remove  the  opportunity  thus  offered  for  exploitation, 
and  to  do  away  with  the  abuses  which  have  crept  into  the 
present  method,  it  has  been  suggested  that  certificates  of  stock 
should  express  no  par  value  but  represent  merely  a  fractional 
interest  in  the  corporate  assets.  The  New  York  Public  Service 
Commission  at  an  early  date  approved  the  suggestion:  "It 
may  well  be  considered  a  matter  worthy  of  grave  reflection 


PAR  VALUE  AND  VALUE  OF  STOCK 


79 


whether  in  the  case  of  at  least  all  corporations  hereafter  or- 
ganized a  certificate  of  stock  should  have  no  par  value,  but 
should  state  only  that  the  owner  is  entitled  to  a  named  pro- 
portional interest  in  the  corporation.  Every  prospective  pur- 
chaser would  then  be  required  to  get  a  notion  of  the  value  of 
the  property  from  a  source  other  than  the  sums  named  on  the 
certificate.  The  owner  could  not  expect  or  demand  returns 
upon  a  fictitious  basis.  The  real  would  supersede  the  unreal 
in  most  investigations  as  to  corporate  values."'^ 

The  Railroad  Securities  Commission,  appointed  by  ex- 
President  Taft  to  investigate  the  matter  of  federal  supervision 
of  railroad  securities,  also  approved  the  suggestion:  "We  do 
not  believe  that  the  retention  of  the  hundred  dollar  mark,  or 
any  other  dollar  mark,  upon  the  face  of  the  share  of  stock,  is 
of  essential  importance.  We  are  ready  to  recommend  that 
the  law  should  encourage  the  creation  of  companies  whose 
shares  have  no  par  value  and  permit  existing  companies  to 
change  their  stock  into  shares  without  par  value  whenever 
their  convenience  requires  it.  After  such  conversion  any  new 
shares  could  be  sold  at  such  prices  as  was  deemed  desirable  by 
the  Board  of  Directors  ....  As  between  the  two  alterna- 
tives of  permitting  the  issue  of  stock  below  par  or  authorizing 
the  creation  of  shares  without  par  value,  the  latter  seems  to 
this  Commission  the  preferable  one.  It  is  true  that  it  will  be 
less  easy  to  introduce  than  the  other  because  it  is  less  in  ac- 
cord with  existing  business  habits  and  usages,  but  it  has  the 
cardinal  merit  of  accuracy.  It  makes  no  claim  that  the  share 
thus  issued  is  anything  more  than  a  participation  certificate." 

In  estimating  the  force  of  the  Commission's  recommenda- 
tions it  will  be  well  to  keep  in  mind  the  fact  that  it  emphasizes 
the  desirability  of  issuing  shares  without  par  value  as  an 
alternative  of  issuing  at  less  than  par  stock  having  a  par  value. 
It  does  not  require  very  much  analysis  to  see  that  it  cannot  be 


«  N.  Y.  C.  &  H.  R.  R.  R.  Co.  and  R.  &  E.  Rapid  Ry.  Co.,  i  P.  S.  C.  Rep.  (2nd  D., 
N.  Y.)  294  (315). 


8o  CAPITAL   STOCKS 

such  an  alternative,  for  the  considerations  which  will  lead 
one  to  purchase  stock  having  a  par  value  and  offered  at  a  dis- 
count cannot  apply  to  stock  having  no  par  value  and  where 
there  can  therefore  be  no  discount. 

§  37-  (i)  New  York  Statute  as  to  Shares  Without  Par  Value 
In  19 1 2  New  York  amended  its  stock  corporation  law  so 
as  to  permit  the  issue  of  stock  without  par  value.  The  statute^ 
applies  to  corporations  which  are  not  moneyed  corporations 
(i.e.,  banks,  trust  companies,  etc.)  and  which  are  not  subject 
to  the  jurisdiction  of  the  Public  Service  Commissions.  It  pro- 
vides that  the  certificate  of  incorporation  may  provide  "for  the 
issuance  of  the  shares  of  stock  of  such  corporation,  other  than 
preferred  stock  having  a  preference  as  to  principal,  without 
any  nominal  or  par  value.    The  certificate  must  set  forth: 

"The  amount  of  capital  with  which  the  corporation  will 
carry  on  business,  which  amount  shall  not  be  less  than  the 
amount  of  preferred  stock  (if  any)  authorized  to  be  issued 
with  a  preference  as  to  principal,  and  in  addition  thereto  a 
sum  equivalent  to  five  dollars  or  some  multiple  of  five  dollars 
for  every  share  authorized  to  be  issued  other  than  such  pre- 
ferred stock;  but  in  no  event  shall  the  amount  of  such  capital 
be  less  than  five  hundred  dollars." 

"Such  corporation  may  issue  and  sell  its  authorized  shares, 
from  time  to  time,  for  such  consideration  as  may  be  prescribed 
in  the  certificate  of  incorporation,  or  as  from  time  to  time  may 
be  fixed  by  the  board  of  directors  pursuant  to  authority  con- 
ferred in  such  certificate,  or  if  such  certificate  shall  not  so  pro- 
vide, then  by  the  consent  of  the  holders  of  two-thirds  of  each 
class  of  shares  then  outstanding  given  at  a  meeting  called  for 
that  purpose  in  such  manner  as  shall  be  prescribed  by  the  by- 
laws. Any  and  all  shares  issued  as  permitted  in  this  section 
shall  be  deemed  fully  paid  and  non-assessable  and  the  holder 

'  Stock  Corporation  Law,  Section  19.  Italics  in  quoted  parts  are  not  to  be  found 
in  the  original. 


PAR  VALUE  AND  VALUE  OF  STOCK       gl 

of  such  shares  shall  not  be  liable  to  the  corporation  or  its 
creditors  in  respect  thereof." 

A  well-known  commentator  ^  on  the  New  York  statute 
states  that  while  the  method  is  a  "radical  innovation,"  it  "is  in 
accord  with  the  views  advocated  by  profound  thinkers  re- 
specting a  remedy  arising  from  the  evil  of  overcapitalization." 
Perhaps  it  is  not  as  much  of  a  radical  innovation  as  is  gen- 
erally supposed,  however;  it  is  more  of  a  reversion  to  the 
original  conception  of  shares  in  the  joint-stock  type  of  asso- 
ciations of  the  sixteenth  and  seventeenth  centuries,  although 
their  shares  were  not  issued  under  the  privilege  of  limited 
liability.  Par  value  was  introduced  as  a  convenient  method 
of  indicating  the  division  of  capital  stock  into  fractional 
shares,  and  the  uses  to  which  it  has  since  been  put  have  been 
directed  very  largely  by  the  principle  of  limited  liability  and 
the  theory  to  which  that  principle  gave  rise,  viz.,  that  capital 
stock  was  to  be  kept  intact  for  the  protection  of  creditors.  The 
statute  quoted  itself  implies  that  the  par  value  had  some  neces- 
sary functions  to  perform,  for  stock  preferred  as  to  principal 
is  still  to  carry  a  par  value,  and  so  far  as  the  other  stock  is 
concerned,  if  the  price  of  issue  can  be  fixed  by  the  certificate 
of  incorporation  as  the  statute  specifies  may  be  done,  it  be- 
comes a  debatable  question  whether  after  all  there  has  been 
any  radical  departure  from  the  method  of  issuing  stock  with 
a  par  value. 

§  38.     (2)  Characteristics  Compared  with  Par  Value  of  Shares 

Removing  the  par  value  is  not  enough;  standing  by  itself 
that  change  does  not  interpose  any  obstacle  to  the  practices 
which  have  been  the  means  of  working  overcapitalization  here- 
tofore. Take,  for  instance,  the  device  of  issuing  shares  in 
exchange  for  property  or  services  accepted  at  an  overvalua- 
tion; if  the  shares  have  a  par  value,  the  acceptor  of  the  shares 
may  reap  a  profit  by  reselling  to  those  who  will  assume  that 

*  White  on  Corporations,  8th  Ed.,  page  371. 


82  CAPITAL  STOCKS 

the  actual  price  paid  for  them  upon  issue  equaled  that  paid  for 
other  shares  of  the  same  issue.  If  on  the  other  hand  the 
shares  have  no  par  value,  the  acceptor  of  the  shares  in  ex- 
change for  property  or  services  has  precisely  the  same  oppor- 
tunity for  profit  by  reselling  to  those  who  will  likewise  assume 
that  those  shares  had  been  issued  for  consideration  equaling 
that  paid  for  other  shares  of  that  issue,  since  all  shares  of  the 
one  issue  are  required  to  be  offered  for  sale  upon  like  con- 
sideration. 

Earlier  in  this  chapter  the  reasons  for  carrying  the  par  value 
of  capital  stock  upon  the  books  at  par  were  discussed.  Every 
one  of  those  reasons  applies  with  equal  force  and  effect  to  the 
proceeds  of  the  shares  without  par  value,  so  that  if  confusion 
was  caused  by  the  former  method,  confusion  will  be  caused 
by  the  latter  as  well.  In  place  of  the  par  value  of  capital 
stock  now  appearing  on  the  liabilities  side  of  the  balance  sheet, 
there  will  be  substituted  the  total  proceeds  of  the  shares 
issued;  this  amount,  increased  or  decreased  by  the  corporate 
surplus  or  deficit,  and  divided  by  the  number  of  shares,  will 
give  the  apparent  or  book  value  of  the  shares  at  any  particular 
date — precisely  the  same  formula  which  is  necessary  in  de- 
termining the  value  of  shares  carrying  par  value,  and  there- 
fore subject  to  like  limitations.  If  it  were  possible,  because 
of  the  absence  of  par  value,  to  omit  making  a  separate  entry 
relating  to  capital  stock,  a  single  item,  e.g.,  "Proprietorship," 
might  represent  the  total  of  the  shareholders'  interest,  to  wit, 
the  original  investment  increased  or  decreased  by  profits  or 
losses.  It  is  very  doubtful  whether  such  a  method  would 
prove  satisfactory.  In  connection  with  the  accounting  prac- 
tice, the  reader  may  turn  back  to  the  first  chapter  and  note  the 
practice  of  the  joint-stock  express  companies  whose  shares 
have  no  par  value  but  who,  nevertheless,  "for  convenience  re- 
port on  the  liabilities  side  of  the  balance  sheet  at  a  nominal 
par  value  the  shares  representing  the  beneficial  interest  of 
members." 


PAR  VALUE  AND  VALUE  OF  STOCK       83 

To  sum  up  the  matter,  the  fact  is  that  the  omission  of 
the  par  value  is  not  a  remedy  sufficient  in  itself  to  cure  the 
existing  evils;  to  be  effective,  it  must  be  accompanied  by  in- 
telligent and  constructive  control  over  organization  and  ad- 
ministration, and  an  active  governmental  control  of  account- 
ing, or  the  general  acceptance  of  uniform  accounting  prac- 
tices, supplemented  by  frequent  reports  prepared  in  a  form 
readily  reflecting  the  status  of  proprietorship  interests. 
Given  these  conditions,  however,  it  is  undoubtedly  true  that 
the  abuse  of  par  value  designations  could  also  be  prevented. 
The  framers  of  the  New  York  statute  undoubtedly  were  of 
that  opinion,  to  such  an  extent  that  corporations  within  the 
jurisdiction  of  the  Public  Service  Commissions  were  excluded 
from  the  operation  of  the  amendment  permitting  the  issue  of 
shares  without  par  value. 

There  is  no  intention  here  to  deprecate  the  activities  of 
those  who  have  advocated  the  omission  of  the  par  value,  for 
even  though  that  in  itself  will  not  accomplish  the  ends  ex- 
pected of  it,  still  it  will  make  easier  the  introduction  of  other 
remedies.  The  device  of  shares  without  par  value  must  neces- 
sarily be  experimented  with  for  some  time  to  come,  and  out 
of  the  experimentation  there  may  develop  an  effective  method 
for  correcting  the  abuses  of  the  past  and  reflecting  in  current 
records  the  actual  value  of  shares  of  stock. 


CHAPTER    V 

STOCKHOLDERS    AND    CORPORATE    CONTROL 

§  39.     Corporate  Control 

A  share  of  capital  stock  in  representing  proprietary  inter- 
est, also  represents,  as  a  necessary  incident  of  proprietorship, 
a  share  in  the  actual  present  control  and  management  of  the 
corporation,  to  be  exercised  through  the  vote  of  the  stock- 
holder. 

The  power  of  control  is  an  inherent  attribute  of  stock,  but 
stock  possessing  this  power  at  the  time  of  organization  of  the 
corporation  may  later  part  with  it  to  gain  some  other  distinct 
advantage.  The  advantage  gained  may  be  the  assurance  of 
a  specified  income  in  preference  to  the  other  stockholders,  or 
the  securing  of  additional  capital  for  the  enterprise,  where 
those  advancing  the  capital  stipulate  as  a  condition  that  they 
be  permitted  to  exercise  a  certain  degree  of  specific  control  or 
that  certain  others  shall  not  exercise  control.^  Such  modi- 
fication of  the  power  of  control  may  be  accomplished  (a)  by 
express  contract  between  the  stockholders,  or  between  the  cor- 
poration (acting  pursuant  to  the  authority  of  the  stock- 
holders) and  the  bondholders;  or  (b)  by  specific  provisions  of 
the  certificate  of  incorporation;  or  (c)  through  by-laws 
adopted  upon  organization,  in  those  cases  where  there  is  an 
implied  contract  made  on  behalf  of  the  stockholders  and  run- 
ning with  the  shares  of  stock. 

The  control  of  stockholders  over  the  ordinary  affairs  of 
the  corporation  is  an  indirect  one.  The  affairs  of  a  corpora- 
tion are  administered  by  directors  acting  under  the  rules  estab- 


*  See  Chapter  VI,  §  56,  and  Chapter  VIII,  §  92. 

84 


STOCKHOLDERS  AND  CORPORATE  CONTROL 


85 


lished  for  the  management  of  the  corporation  by  the  charter 
or  by-laws.  The  active  present  control  of  a  stockholder  in  the 
management  of  the  corporation  extends  only  to  the  formula- 
tion or  amendment  of  those  rules  and  to  the  election  of  direc- 
tors. On  matters  affecting  the  corporate  status,  however,  such 
as  the  increase  of  capital  stock,  mortgaging  the  corporate 
property,  voluntary  dissolution,  etc.,  the  stockholder  exercises 
a  direct  control,  since  by  statute  these  acts  must  be  authorized 
by  the  stockholders  themselves. 

§  40.     Voting  Rights 

The  voting  rights  vested  in  capital  stock  can  be  exercised 
only  by  the  owner  of  the  stock  or  someone  acting  for  him. 
Except  in  the  case  of  voting  trusts,  described  in  §  42,  the 
stockholder  may  not  alienate  to  another  the  voting  rights  at- 
tending his  holdings;  in  other  words,  voting  rights  may  not 
be  vested  in  and  be  exercised  by  any  one  independently  of  the 
beneficial  ownership  of  the  shares  of  stock  to  which  those 
rights  attached.  In  New  York,  as  well  as  in  many  other 
states,  it  is  a  statutory  misdemeanor  for  any  person  entitled  to 
vote  at  any  meeting  of  the  stockholders  or  bondholders  to  sell 
his  vote,  or  to  issue  "a  proxy  to  vote  to  any  person  for  any 
sum  of  money  or  thing  of  value,  except  as  expressly  author- 
ized by  law."  ^  This  statute  was  to  remedy  certain  abuses 
which  are  thus  described  by  Sterne  ^  in  referring  to  the  in- 
vestigation by  the  Hepburn  Committee,  appointed  in  1879, 
of  the  abuses  alleged  to  exist  in  the  management  of  railroads 
in  New  York  State: 

"The  attention  of  the  Committee  had  been  drawn  to  the 
evils  connected  with  the  proxy  system,  by  which  railways  were 
captured  by  the  mere  purchase  of  voting  power  from  per- 
sons, mainly  bankers,  in  whose  names  large  amounts  of  stock 
were  registered,  but  which  had  been  sold  and  distributed  to 


*  Penal  Law,  Section  668. 

'  Sterne  on  "Railroads  in  the  United  States." 


86  CAPITAL  STOCKS 

their  customers,  and  for  prudent  reasons  were  left  standing 
in  their  names  on  the  stock  books  of  the  companies.  This 
situation  gave  to  such  persons  a  large  voting  power  in  the 
railway  without  a  substantial  interest  or  stake  in  the  result  of 
the  vote.  To  persons  who  desired  to  capture  the  road,  it  was 
a  strong  temptation  to  purchase  such  voting  power;  and  to 
persons  who  had  no  perrnanent  interest  in  the  road,  it  was  a 
corresponding  temptation  to  sell  the  power,  the  evil  effects  of 
the  sale  of  which  they  were  not  personally  called  to  bear." 

The  temptation  has  proved  a  universal  one  and  its  elimina- 
tion by  legislation  has  been  difficult.  The  unlawful  exercise 
of  voting  rights  apart  from  the  beneficial  ownership  of  the 
shares  is  a  punishable  offense,  the  penalties  in  many  European 
countries  being  far  more  severe  than  any  prescribed  in  the 
United  States.  But  while  penal  laws  are  clear  in  their  terms, 
as  far  as  they  go,  their  enforcement  is  not  easy  because  often 
the  infringement  seems  of  no  particular  moment  and  passes 
unnoticed.  In  other  cases  where  the  results  would  be  such  as 
to  attract  attention,  the  parties  in  interest  are  careful  to  choose 
a  safer  method. 

The  chief  objection  to  alienating  voting  rights  is  that 
thereby  those  first  entitled  to  the  exercise  of  voting  rights  by 
virtue  of  proprietorship  are  afforded  an  opportunity  for  realiz- 
ing profits  which  do  not  spring  out  of  the  corporate  enter- 
prise and  its  success,  but  rather  out  of  the  abuse  and  betrayal 
of  the  corporate  interests  by  the  proprietor  who  places  a  higher 
value  upon  a  money  or  other  consideration  received  from  out- 
side than  he  does  upon  the  power  to  direct  the  business  he  is 
supposed  to  own.  In  preventing  the  alienation  of  voting 
rights,  therefore,  it  is  sought  to  hold  the  stockholders  to  a 
more  conscientious  exercise  of  their  power  for  the  single  and 
undivided  purpose  of  maintaining  the  corporate  welfare.  For 
the  successful  attainment  of  this  object  it  is  also  necessary  to 
prevent  the  shareholder  from  exercising  his  voting  rights  un- 
der the  influence  of  a  bribe.     This  would  be  as  serious  an 


STOCKHOLDERS  AND  CORPORATE  CONTROL 


87 


offense  as  the  other,  and  is  punishable  as  are  all  offenses  of 
bribery.  In  other  countries  where  the  regulation  of  these 
matters  is  more  strict,  the  penal  laws  specifically  provide  for 
fine  or  imprisonment  or  both  of  the  shareholder  or  duly  ap- 
pointed proxy  who  agrees  to  vote  in  some  particular  way,  or 
not  to  vote  at  all,  in  consideration  of  some  special  advantage 
to  accrue  to  him.  To  safeguard  still  further  the  corporate  in- 
terests from  being  made  subservient  to  the  private  interests  of 
the  shareholders  or  of  some  of  them,  the  statutes  of  these 
other  countries  prohibit  a  shareholder  from  voting  in  opposi- 
tion to  the  obligations  which  he  may  have  incurred  toward  the 
corporation,  or  on  a  resolution  which  discharges  or  relieves 
him  from  the  performance  of  a  duty,  or  one  relating  to  a 
transaction  or  litigation  between  the  company  and  himself. 

§  41.    Proxies 

The  word  "proxy"  is  a  contraction  of  the  old  word  "pro- 
curacy"— "procuration" — a  term  still  used  in  connection  with 
negotiable  instruments.  It  has  a  dual  meaning,  referring  both 
to  the  person  who  is  authorized  to  act  for  another  and  to  the 
written  instrument  which  gives  him  his  authority. 

The  right  of  a  stockholder  to  vote  by  proxy  is  not  an 
absolute  one  but  is  given  him  through  provisions  in  the  charter 
or  by  the  statutes  of  the  state  in  which  the  corporation  is  or- 
ganized. The  statutes  of  practically  all  states  give  him  this 
right. 

The  proxy  system  has  been  subject  to  many  abuses  and  mis- 
uses, such  as  those  already  referred  to,  and  in  spite  of  much 
remedial  legislation,  many  evils  still  exist  and  will  continue  to 
exist  so  long  as  stockholders  consider  their  holdings  simply  as 
investments,  involving  no  obligation  of  active  interest  in  the 
affairs  of  the  corporation,  which  they  are  content  to  leave  to 
a  few  men  to  manage  as  they  see  fit,  provided  the  apparent 
integrity  of  their  investment  is  not  impaired.  Because  of  this 
indifference,  the  minority  often  control  corporation  action. 


88  CAPITAL   STOCKS 

§  42.     Voting  Trusts 

One  special  form  of  arrangement  under  which  voting 
rights  may  be  absokitely  alienated  from  the  ownership  of  the 
stock  is  permitted  under  the  laws  of  many  states  in  what  is 
known  as  a  voting  trust  agreement. 

It  is  sometimes  desirable  that  the  voting  power  of  a  num- 
ber of  stockholders  should  be  unified,  or  "pooled,"  in  the  hands 
of  a  few  persons  for  a  definite  time.  The  stockholders  de- 
siring to  participate  in  the  arrangement  designate  certain  per- 
sons as  "voting  trustees"  to  exercise  their  combined  voting 
powers ;  then,  under  a  written  agreement,  they  surrender  their 
stock  certificates  which  are  transferred  to  the  names  of  the 
trustees  on  the  stock  book.  Each  stockholder  in  exchange  for 
his  certificate  of  stock  receives  from  the  trustees  a  "voting  trust 
certificate"  corresponding  somewhat  to  an  ordinary  bank  cer- 
tificate of  deposit  and  representing  an  aggregate  amount  equal 
to  the  stock  deposited.  These  certificates  are  negotiable  and 
are  transferable  on  special  books  kept  for  the  purpose  by  the 
voting  trustees.  The  effect  of  this  exchange  of  certificates  is 
temporarily  to  divest  the  stockholder  of  the  legal  title  to  his 
shares,  which  becomes  vested  in  the  voting  trustees,  but  to 
retain  in  himself  the  beneficial  interest.  Dividends  declared 
during  the  voting  trust  accrue  in  favor  of  the  stockholders. 

The  duration  of  a  voting  trust  is  limited  by  statute  in  New 
York  to  five  years.  A  copy  of  the  agreement  must  be  filed  in 
the  office  of  the  corporation  and  kept  open  for  the  inspection 
of  stockholders.  The  entry  upon  the  stock  book  transferring 
the  stock  to  the  names  of  the  trustees  must  also  indicate  that 
the  transfer  is  by  virtue  of  a  voting  trust  agreement. 

An  agreement  such  as  this  comes  within  the  laws  governing 
contracts  and  will  be  invalid  if  its  purpose  is  against  public 
policy,  contrary  to  law,  unconscionable  in  its  attempt  to  ad- 
vance the  interests  of  the  parties  thereto  at  the  expense  of  the 
minority  stockholders,  to  perpetrate  fraud,  or  to  effect  an 
illegal  combination. 


STOCKHOLDERS  AND  CORPORATE  CONTROL   89 

An  arrangement  of  this  kind  must  not  be  confused  with 
that  under  which  stockholders  Hving  at  a  distance  from  each 
other  or  from  the  corporate  office,  or  unable  to  give  the  neces- 
sary personal  attention,  for  the  purpose  of  concerted  action 
give  to  a  committee  of  their  number  the  right  to  vote  their 
stock,  which  they  place  in  a  designated  depositary.  This  plan 
is  very  often  resorted  to  in  the  case  of  reorganization  com- 
mittees; it  is  an  extension  of  the  proxy  system  and  any  stock- 
holder may  retire  from  it  at  his  option.  It  differs  from  the 
voting  trust  in  that  in  the  latter  the  voting  rights  of  stock- 
holders are  absolutely  alienated  and  may  be  exercised  by  the 
trustees  as  they  see  fit. 

§  43.     Majority  Control 

It  is  a  general  rule  applicable  to  all  associations,  whether 
incorporated  or  not,  that  a  majority  of  shareholders  or  mem- 
bers may  bind  the  whole  association,  while  acting  in  the  man- 
ner and  for  the  purposes  originally  agreed  upon;  hence  the 
control  of  a  corporation  is  lodged  in  the  hands  of  the  holders 
of  a  majority  of  the  outstanding  capital  stock,  irrespective  of 
the  amount  authorized.  As  a  matter  of  fact,  in  our  large  cor- 
porations where  the  number  of  stockholders  runs  into  the 
thousands  and  tens  of  thousands,  less  than  a  numerical  ma- 
jority is  sufficient  to  exercise  control.  It  may  be  stated  as  a 
general  rule  that  the  greater  the  number  of  stockholders,  the 
smaller  is  the  proportion  of  shares  necessary  to  exercise  cor- 
porate control.  The  "uncontrolling"  shareholders,  although 
owning  a  majority  of  the  stock,  have  ordinarily  no  way  of 
getting  together  for  concerted  action,  and  very  often  know  but 
little,  if  anything  at  all,  of  the  corporate  affairs.  Only  a  small 
proportion  of  them  read  the  reports  sent  them,  if  any  are  pub- 
lished, while  the  number  of  those  who  read  and  understand 
these  reports  is  still  smaller.  It  is  this  indifference  which  per- 
mits one  individual  holding  a  minority,  or  a  number  of  in- 
dividuals holding  shares  totaling  to  a  small  part  of  the  aggre- 


90 


CAPITAL   STOCKS 


gate  but  who  work  in  concert,  to  become  controlling  and  to 
maintain  their  control  as  effectually  as  if  they  owned  a  ma- 
jority of  the  shares. 

In  the  decree  of  dissolution  of  the  Union  Pacific,  the 
Supreme  Court  of  the  United  States,  referring  to  the  owner- 
ship by  the  Union  Pacific  of  only  46  per  cent  of  the  Southern 
Pacific  stock,  pointed  out  that  the  ownership  of  less  than  a 
legal  majority  could  carry  absolute  control.  "It  may  be  true 
that  in  small  corporations  the  holding  of  less  than  a  majority 
of  the  stock  would  not  amount  to  control,  but  the  testimony 
in  this  case  is  ample  to  show  that,  distributed  as  the  stock  is 
among  many  stockholders,  united  ownership  of  46  per  cent  is 
ample  to  control  the  operations  of  the  corporation."  The 
"uncontrolling"  shareholders,  when  they  became  stockholders, 
had  probably  no  desire  to  take  an  active  part  in  corporate 
affairs,  and  so  long  as  the  integrity  of  their  investment  is 
maintained  they  trouble  themselves  but  little  as  to  matters  of 
administration  or  policy;  too  often  they  are  content  to  give 
their  proxies,  by  filling  in  blanks  sent  them  for  that  purpose, 
to  agents  of  the  controlling  shareholders  without  any  question 
arising  in  their  minds  as  to  the  fitness  of  the  proxy  seeker  to 
continue  in  control  of  the  property. 

At  meetings  of  stockholders  for  the  election  of  directors 
and  the  transaction  of  ordinary  routine  business,  the  statute 
does  not  require  any  specified  proportion  of  the  capital  stock 
to  be  represented.  The  by-laws  will  define  a  quorum.  The 
vote  of  a  majority  of  the  stock  represented  is  sufficient  to 
elect  or  to  adopt  routine  resolutions.  In  special  matters,  e.g., 
the  increase  of  capital  stock,  amendment  of  charter,  mortgag- 
ing of  property,  consolidation  with  another  corporation,  etc., 
the  statute  requires  unanimous  action  of  stockholders  repre- 
senting a  majority  of  the  total  outstanding  shares  of  capital 
stock.  Similar  requirements  may  be  imposed  by  the  conditions 
of  preferment  of  one  class  of  stock,  or  by  agreement  between 
the  stockholders  and  bondholders. 


STOCKHOLDERS  AND  CORPORATE  CONTROL 


91 


§  44.     Special  Responsibilities  of  Majority  Stockholders 

A  majority  or  controlling  stockholder  is  subject  to  certain 
responsibilities  towards  the  minority  stockholders  in  dealing 
with  the  corporate  property.  It  has  been  repeatedly  held  by 
our  courts  that  a  majority  stockholder  stands  in  a  peculiar 
position  as  regards  the  minority  holders;  that  he  becomes  a 
trustee  for  them, 

"The  holder  of  the  majority  of  the  stock  of  a  corporation 
has  the  power,  by  the  election  of  biddable  directors  and  by  the 
vote  of  his  stock,  to  do  everything  that  the  corporation  can  do. 
His  power  to  control  and  direct  the  action  of  the  corporation 
places  him  in  its  shoes,  and  constitutes  him  the  actual,  if  not 
the  technical,  trustee  for  the  holders  of  the  minority  of  the 
stock.  He  draws  to  himself  and  uses  all  the  powers  of  the 
corporation.  In  effect  he  holds  an  irrevocable  power  of  attor- 
ney from  the  minority  stockholders  to  manage  and  to  sell  the 
property  of  the  corporation,  for  himself  and  for  them.  Times, 
places,  and  notices  of  meetings  of  the  directors  and  of  meet- 
ings of  the  stockholders  become  of  secondary  importance, 
because  the  presence,  the  vote,  and  the  protest  of  holders  of 
the  minority  of  the  stock  are  unavailing  against  the  will  of  the 
holder  of  the  majority.  They  can  act  and  contract  regarding 
the  corporate  property,  they  can  preserve  and  protect  their 
interests  in  it,  only  through  him  and  through  the  courts. 

"The  devolution  of  unlimited  power  imposes  on  a  single 
holder  of  a  majority  of  the  stock  a  correlative  duty,  the  duty 
of  a  fiduciary  or  agent,  to  the  holders  of  the  minority  of  the 
stock,  who  can  act  only  through  him;  the  duty  to  exercise 
good  faith,  care,  and  diligence  to  make  the  property  of  the 
corporation  produce  the  largest  possible  amount,  to  protect  the 
interests  of  the  holders  of  the  minority  of  the  stock,  and  to 
secure  and  pay  over  to  them  their  just  proportion  of  the  in- 
come and  of  the  proceeds  of  the  corporate  property.  Any 
sale  of  the  property  of  the  corporation  by  him  to  himself  for 
less  than  he  could  obtain  for  it  from  another,  or  any  other 


92  CAPITAL   STOCKS 

act  in  his  interest  to  the  detriment  of  the  holders  of  the  minor- 
ity of  the  stock,  becomes  a  breach  of  duty  and  of  trust,  renders 
the  sale  or  act  voidable  at  the  election  of  the  minority  stock- 
holders, and  invokes  plenary  relief  from  a  court  of  chancery."* 

Not  only  does  this  relationship  exist  in  the  case  of  an  in- 
dividual majority  stockholder,  but  also  of  a  group  of  stock- 
holders and  of  a  corporation  owning  a  majority  of  stock: 

"The  law  requires  of  the  majority  of  the  stockholders  the 
utmost  good  faith  in  their  control  and  management  of  the 
corporation  as  regards  the  minority,  and  in  this  respect  the 
majority  stand  in  much  the  same  attitude  towards  the  minority 
that  the  directors  sustain  towards  all  the  stockholders.  Hence, 
where  the  majority  are  interested  in  another  corporation,  and 
the  two  corporations  have  contracts  between  them,  it  is 
fraudulent  for  that  majority  to  manage  the  affairs  of  the  first 
corporation  for  the  benefit  of  the  second.  A  court  of  equity 
will  intervene  and  protect  the  minority  upon  an  application  by 
the  latter."  ^ 

"Where  ....  a  majority  of  the  stock  is  owned  by  a  cor- 
poration or  a  combination  of  individuals,  and  it  assumes  the 
control  of  another  company's  business  and  affairs  through  its 
control  of  the  officers  and  directors  of  the  corporation,  it 
would  seem  that  for  all  practical  purposes,  it  becomes  the  cor- 
poration of  which  it  holds  a  majority  of  stock,  and  assumes 
the  same  trust  relation  towards  the  minority  stockholders  that 
a  corporation  itself  usually  bears  to  its  stockholders,  and 
therefore,  under  such  circumstances,  the  rule  stated  ....  ap- 
plies to  majority  stockholders  who  control  the  affairs  of  the 
company,  as  well  as  to  its  directors  and  officers."  ^ 

§  45.     Minority  Representation 

There  are  those  who,  through  the  system  of  lodging  con- 
trol of  corporate  affairs  in  the  hands  of  a  bare  majority,  have 


*  Wheeler  v.  Abiline  Natl.  Bank  Bldg.  Co.,  159  Fed.  Rep.  391   (2,93-394)- 
"2  Cook  on  Corporations,  7th  Ed.,  §663. 

*  Farmers'  Loan  &  Trust  Co.  v.  New  York  &  Northern  R.  Co.,  150  N.  Y.  410  (430). 


STOCKHOLDERS  AND  CORPORATE  CONTROL 


93 


come  into  power  and  have  been  able  to  perpetuate  themselves 
in  power  through  ownership  of  that  controlling  interest  or 
their  knowledge  of  where  the  votes  are,  together  with  facili- 
ties for  controlling  those  votes.  These  have  not  always  main- 
tained the  integrity  of  stockholders'  investments  but  have 
allowed  such  values  to  be  impaired  in  order  that  their  own 
personal  fortunes  might  be  promoted.  Majority  stockholders 
have  not  always  recognized  their  responsibilities  to  the  minor- 
ity stockholders;  they  have  used  their  power  of  control  as  a 
means  of  advancing  their  own  private  interests  at  the  expense 
of  other  stockholders'  investments.  Against  the  acts  of  such 
persons  the  law  has  afforded  scant  relief,  for  they  are  careful 
to  adhere  strictly  to  the  technicalities  of  the  corporate  form, 
and  have  otherwise  adopted  methods  which  hide  successfully 
the  indications  of  wrong-doing. 

To  protect  stockholders  from  the  abuse  of  power  by  the 
directorate,  it  has  been  sought  to  devise  a  method  of  limiting 
the  electing  power  of  the  majority  holders  while  correspond- 
ingly increasing  that  of  the  minority  holders. 

One  method  devised  has  been  that  of  inserting  in  the 
charter  a  provision  that  no  stockholder,  either  in  his  own  right 
or  by  proxy,  shall  cast  more  than  a  certain  proportion,  for 
instance,  one-fourth,  of  all  the  votes  cast  at  an  election  of 
directors,  or  vote  for  more  than  two-thirds  of  the  directors 
to  be  elected. 

A  more  general  method,  and  one  provided  for  in  the 
statutes  of  many  states,  is  that  of  cumulative  voting.  At  an 
election  of  directors  a  stockholder  may  vote  his  holdings  for 
each  candidate,  and  on  each  vote  taken  the  ratio  of  the  number 
of  votes  cast  by  him  to  the  total  number  remains  the  same. 
Under  the  cumulative  plan  he  is  permitted  to  cast  as  many 
votes  as  will  equal  the  number  of  his  shares  of  stock  multi- 
plied by  the  number  of  directors  to  be  elected;  he  may  cast 
the  total  number  in  favor  of  one  candidate  or  divide  among 
two  or  more,  hence  the  ratio  of  the  number  of  votes  cast  by 


94 


CAPITAL   STOCKS 


him  to  the  total  number  will  be  greater  in  the  votes  for  some 
directors  than  for  others,  depending  on  the  extent  to  which 
the  minority  holder  has  sought  to  focus  his  strength  on  the 
election  of  one  director,  of  two  directors,  etc.  Thus,  if  there 
are  ten  directors  to  be  elected,  the  holder  of  twenty-five  shares, 
instead  of  being  obliged  to  cast  not  more  than  twenty-five 
votes  for  each  candidate,  may  cast  the  total  two  hundred  and 
fifty  votes  in  favor  of  one  candidate,  or  may  divide  that  num- 
ber of  votes  among  two  or  more  candidates  as  may  be  neces- 
sary to  secure  representation  on  the  directorate. 

§  46.     Qualifications  of  Stockholders 

As  a  general  rule,  all  natural  persons  not  placed  under  some 
legally  established  disability  may  become  stockholders,  and 
share  in  the  advantages,  exercise  the  rights,  and  be  subjected 
to  the  duties  created  by  that  relationship. 

Corporations  may  become  stockholders  in  other  corpora- 
tions provided  that  the  acquiring  and  holding  of  shares  of 
stock  is  one  of  the  powers  granted  them  by  their  charter. 
While  a  corporation  may  become  a  stockholder,  it  seems  that 
under  no  circumstances  can  it  become  an  incorporator;  for 
instance,  where  the  certificate  of  incorporation  is  required  to 
name  the  incorporators  and  state  the  number  of  shares  sub- 
scribed for  by  each  of  them,  none  of  those  names  may  be  that 
of  another  corporation.  This  is  logical;  a  corporation  is  a 
legal  entity  which  may  be  created  only  through  the  agency  of 
natural  persons. 

While  corporations  may,  in  general,  become  stockholders, 
public  service  corporations  are  subjected  to  certain  restrictions. 
In  New  York,  for  instance,  the  Public  Service  Commissions 
Law  forbids  any  stock  corporation  (except  railroad,  street 
railroad,  electrical,  gas,  telephone  or  telegraph  corporations) 
to  acquire  or  hold  more  than  10  per  cent  of  the  capital  stock 
of  a  railroad,  street  railroad,  electrical,  gas,  telephone  or  tele- 
graph company.     Corporations  which  upon  the  enactment  of 


STOCKHOLDERS  AND  CORPORATE  CONTROL 


95 


the  statute  already  held  a  majority  of  the  stock  of  any  corpora- 
tion can  thereafter,  with  the  consent  of  the  Commission, 
acquire  the  remainder  of  the  outstanding  capital  stock  of  that 
corporation.  Railroad  corporations  may  not,  without  the  con- 
sent of  the  Commission,  acquire  shares  of  stock  of  other  rail- 
road or  street  railroad  corporations;  street  railroad  corpora- 
tions, of  railroad  or  other  street  railroad  or  electrical  cor- 
porations; electrical  corporations,  of  street  railroad  corpora- 
tions or  of  other  electrical  corporations;  gas  corporations,  of 
other  gas  corporations.  The  corporations  specified  are  also 
prohibited  from  transferring  on  their  books  or  recognizing 
transfers  of  stock  violating  these  prohibitions,  as  already 
noted. 

§  47.     Stock  of  Corporation  Held  by  Itself 

It  is  generally  understood  that  a  corporation  cannot  be  its 
own  stockholder ;  it  cannot  issue  its  own  stock  to  itself.  The 
law  with  its  many  fictions  has  not  accepted  any  device  which 
will  support  that  situation.  Under  some  circumstances,  how- 
ever, it  may  acquire  shares  of  its  stock  which  have  once  been 
legally  issued,  but  shares  thus  reacquired  cannot  be  considered 
as  alive  but  lie  dormant,  not  sharing  corporation  profits  or  con- 
trol. 

Statutes  generally  provide  that  a  corporation  may  repur- 
chase its  own  stock,  but  only  out  of  surplus  profits,  and  the 
New  York  statute  permits  it  to  accept  "shares  of  its  capital 
stock  in  complete  or  partial  settlement  of  a  debt  owing  to  the 
corporation,  which  by  the  Board  of  Directors  shall  be  deemed 
to  be  bad  or  doubtful."  The  prohibition  against  the  acquisition 
of  capital  stock,  except  out  of  surplus  profits,  is  intended  to 
conserve  creditors'  rights  by  preventing  any  attempt  to  dis- 
tribute capital  among  the  stockholders,  thereby  lessening  the 
corporation's  ability  to  meet  its  debts.  Of  course,  it  may  also 
acquire  its  own  stock  by  gift — the  usual  method  where  the 
acquisition  is  incident  to  a  plan  of  reducing  the  capital  stock. 


CHAPTER   VI 

CLASSIFICATION    OF    CAPITAL    STOCK 

§  48.     Authority  for  Classification 

There  is  no  principle  of  law  forbidding  the  members  of 
any  association  to  define  and  fix  as  between  themselves 
the  nature  and  extent  of  their  individual  rights  or  obliga- 
tions. In  the  absence  of  any  agreement  the  law  will,  where  it 
finds  a  common  undertaking,  presume  the  equal  share  of  re- 
sponsibility and  benefit  of  each  one  associated  therewith. 
Thus,  partners  are  jointly  and  severally  liable  on  partnership 
debts  and  share  alike  in  the  profits  or  losses,  but  they  may  by 
agreement  between  themselves  fix  unequal  or  unlike  shares  in 
profits  and  responsibility  for  debts,  subject,  of  course,  to  the 
imperative  condition  that  rights  of  third  parties  are  not 
prejudiced  thereby. 

The  members  of  a  stock  corporation  occupy  a  position  not 
different  from  that  of  the  members  of  any  other  association, 
in  this  respect.  They  also  may  agree  among  themselves  as  to 
the  nature  and  extent  of  their  interests  so  as  to  create  unequal 
or  unlike  rights.  Any  inequality  in  the  measure  of  interest  is 
primarily  taken  care  of  by  the  device  of  shares  of  stock,  each 
representing  an  equal  proportion  of  interest,  so  that  the  num- 
ber of  shares  held  by  each  stockholder  will  definitely  fix  the 
proportion  of  his  interest.  In  this  respect  the  shares  are  all 
alike.  It  is  the  conferring  of  special  privileges  or  preferences 
upon  certain  shares  that  creates  inequality  or  unlikeness  of 
rights,  and  divides  the  stock  into  classes  such  as  preferred 
and  common.  Preferences  most  commonly  conferred  are  in 
respect  of  priority  of  claims  in  the  distribution  of  assets  upon 
dissolution  of  the  corporation,  or  in  the  distribution  of  earn- 

96 


CLASSIFICATION    OF    CAPITAL    STOCK 


97 


ings,  or  in  respect  to  immediate  control  of  the  corporate  affairs. 
The  usual  preference  is  in  regard  to  dividends. 

Prior  to  issue,  classification  of  capital  stock  may  be  effected 
by  proper  provisions  inserted  in  the  certificate  of  incorpora- 
tion; subsequent  classification  or  reclassification  may  be 
effected  likewise  by  amending  the  certificate;  all  shares  of 
stock  issued  will,  of  course,  be  identified  specifically  as  be- 
longing to  one  or  another  class.  It  has  been  held  also  that 
classification  may  be  effected  independently  of  provisions  in 
the  certificate,  by  rules  inserted  in  the  by-laws  at  the  time  of 
organizing  the  corporation;  the  rights  of  the  existing  share- 
holders will  be  modified  accordingly  and  every  subsequent 
shareholder  will  be  charged  with  notice  of  the  preference  and 
held  to  its  terms. 

If  the  authorization  of  a  public  service  commission  is  neces- 
sary to  the  issue  of  stock  in  the  first  instance,  like  authoriza- 
tion is  undoubtedly  necessary  to  any  subsequent  classification 
or  reclassification  of  the  stock.  There  seem  to  have  been  no 
definite  rulings  upon  this  point,  however,  and  instances  are  to 
be  found  where  reclassification  was  carried  out  without  appli- 
cation to  the  commission.  Of  course,  if  the  stock  had  been 
approved  by  the  commission  in  the  first  instance,  subse- 
quent classification  without  its  authority  would  be  altogether 
improper. 

§  49.     Common  Stock 

In  the  absence  of  classification  all  of  the  capital  stock  is 
common  capital  stock,  since  there  is  no  other  class  of  stock 
whose  claims  in  the  distribution  of  assets  are  either  superior 
or  subordinate  to  it. 

It  is  possible  that  there  may  be  outstanding  at  some  time 
but  one  class  of  stock  which  will  be  described  as  "preferred" ; 
this  can  happen  only  where  the  authorized  capital  stock  has 
been  classified  and  the  preferred  portion  alone  has  been  issued, 
the  common  stock  being  temporarily  withheld. 


98  CAPITAL   STOCKS 

It  is  hardly  necessary  to  mention  that  the  rights  of  all 
stockholders  of  common  stock  are  equal  in  all  respects,  and 
if  there  is  no  classification  every  stockholder  is  possessed  of  all 
the  rights  usually  pertaining  to  a  stockholder.  Apparent  ex- 
ceptions to  this  rule  may  be  found,  however;  for  instance, 
the  Bethlehem  Steel  Corporation  has  outstanding  common  "A" 
and  common  "B"  (non-voting)  stocks, 

§  50.    Preferred  Stock 

Where  one  class  of  stock  is  endowed  with  claims  superior 
to  another  in  respect  of  participation  in  profits,  in  the  distribu- 
tion of  assets,  or  in  quality  of  control,  it  is  usually  called  pre- 
ferred stock,  the  stock  over  which  it  is  thus  preferred  being 
designated  either  as  common  stock  or  a  subordinate  issue  of 
preferred,  for  the  classification  of  a  stock  issue  may  be  into 
more  than  two  classes,  each  varying  from  the  others  in  the 
nature  and  extent  of  preferences.  Thus,  the  class  most 
highly  preferred  will  be  first  preferred;  then,  in  descending 
order  of  preference,  will  follow  second  preferred,  third  pre- 
ferred, etc.,  down  to  common.  There  are  comparatively  few 
cases  on  record  where  more  than  two  classes  of  preferred  stock 
have  been  issued,  because  it  becomesvery  difficult  to  work  out 
a  gradation  of  preferences  to  such  an  extent.  The  high  degree 
of  preference  required  to  be  conferred  on  the  first  preferred 
where  there  is  outstanding  a  third  or  less  preferred  issue  would 
approximate  it  so  closely  to  a  bond  as  to  overlap  the  rights 
of  creditors;  moreover,  the  extent  of  preferred  rights  which 
would  necessarily  be  exercised  by  stock  so  highly  preferred 
would  destroy  the  value  of  issues  lower  down  the  scale. 
Ordinarily  the  issue  of  a  modified  form  of  bonds  is  preferable. 

§  51.     Preferment  as  to  Assets 

In  the  absence  of  express  stipulation,  both  preferred  and 
common  stock  share  equally  in  the  distribution  of  the  assets 
upon  dissolution.    It  may  be  agreed,  however,  and  very  often 


CLASSIFICATION   OF   CAPITAL   STOCK  gg 

is,  that  the  preferred  stock  will  share  up  to  par,  or  to  par 
plus  accrued  dividends  (usual  in  the  case  of  cumulative  pre- 
ferred stock)  before  the  common  may  participate  at  all.  Stock 
so  preferred  is  said  to  be  preferred  as  to  assets,  as  to  principal, 
or  as  to  capital.  The  statute  may  require,  as  in  New  Jersey, 
that  all  stock  designated  "preferred"  shall  always  be  pre- 
ferred as  to  assets. 

Stock  preferred  as  to  assets,  after  it  has  received  par  in 
the  distribution  of  assets  will  not  participate  further  until  the 
common  or  other  junior  issues  also  receive  par.  If  any  sur- 
plus remains,  all  classes  will  ordinarily  share  equally  in  its 
distribution,  although  the  terms  of  preference  may  expressly 
fix  the  par  value  of  the  stock  as  the  limit  of  the  right  of  its 
stockholders  to  participate  in  the  distribution. 

It  has  already  been  stated  (§37)  that  the  New  York 
statute  permitting  the  issue  of  shares  without  a  nominal  or  par 
value  expressly  excludes  shares  of  stock  preferred  as  to  prin- 
cipal. 

§  52.    Lien  of  Preferred  Stock 

The  claim  of  preference  in  the  distribution  of  assets  can 
be  exercised  only  during  liquidation  of  the  corporation  and 
then  it  attaches  only  to  the  residue  after  the  claims  of  all  credi- 
tors have  been  met  in  full.  Stockholders  preferred  as  to  assets 
cannot  exercise  any  special  lien  or  claim  on  the  property  of 
the  corporation  not  in  process  of  liquidation.  There  have 
been  attempts  to  confer  upon  preferred  stock  the  right  to  im- 
pose a  specific  lien  on  the  property  of  the  corporation,  but  in- 
stances of  this  nature  are  rare  in  this  country  and  mark  the 
borderland  between  the  status  of  a  stockholder  and  that  of  a 
creditor. 

A  stockholder  is  a  partner  in  an  enterprise,  not  a  creditor; 
his  beneficial  interest  in  the  corporate  business,  evidenced  by 
his  ownership  of  shares  of  its  capital  stock,  is  the  interest  of 
a  partner  subject  to  all  the  risk  (save  the  full  measure  of  liabil- 


lOO  CAPITAL    STOCKS 

ity)  attaching  to  proprietorship  and  partnership.  Although 
the  claims  of  certain  stockholders  may  be  preferred  over  others 
as  to  earnings  and  assets,  they  cannot  become  the  claims  of 
creditors. 

There  have  been  statutes  in  some  states  which  have  been 
thought  to  confer  upon  certain  classes  of  preferred  stock- 
holders at  least  some  of  the  rights  usually  pertaining  only  to 
creditors.  In  order  that  the  relationship  of  debtor  and  creditor 
may  exist,  there  must  be  a  valid  and  absolute  obligation  on 
the  part  of  the  corporation  to  pay  a  stipulated  sum  at  a  knovirn 
or  determinable  future  date,  or  upon  the  happening  of  a  con- 
tingency. The  debt  may  or  may  not  carry  with  it  the  duty  to 
pay  interest  at  a  fixed  rate,  and  at  specified  intervals.  Even 
if  there  is  no  prearranged  date  for  the  repayment  of  the  prin- 
cipal, if  the  interest  provisions  are  such  that  upon  default  the 
one  entitled  thereto  may  sue  as  upon  a  matured  obligation, 
there  is  sufficient  definiteness  in  the  terms  of  repayment  to 
create  the  relationship  of  a  creditor. 

A  stockholder  is  not  a  creditor,  and  it  is  incorrect  to  de- 
scribe as  a  share  of  stock  any  certificate  the  owner  of  which 
will  be  deemed  to  be  a  creditor  by  reason  of  that  ownership. 
Certificates  which  have  that  effect  evidence  a  debt  of  the  cor- 
poration and  should  be  described  accordingly. 

A  Maryland  statute,  for  instance,  authorizes  the  issue  of 
so-called  preferred  stock,  the  holders  of  which  have  priority 
over  subsequent  mortgagees.  An  Ohio  statute  authorizes  the 
issue  of  preferred  stock  redeemable  by  the  company  at  a  fixed 
time,  with  guaranteed  dividends,  the  payment  of  the  principal 
or  dividends  being  secured  by  bond  and  mortgage,  the  holders 
having  no  right  to  vote  and  being  declared  by  statute  exempt 
from  the  liability  to  creditors  which  by  the  state's  constitution 
attaches  to  all  members  of  a  corporation;  these  securities 
are  clearly  in  the  nature  of  funded  debt  securities  and  the 
courts  have  rightly  held  that  the  holders  thereof  are  creditors 
and  not  stockholders. 


CLASSIFICATION   OF   CAPITAL    STOCK  loi 

§  53.     Preferment  in  Dividends 

Preference  in  the  distribution  of  dividends  is  the  most 
usual  basis  of  classification.  In  the  limitation  and  definition 
of  the  conditions  under  which  and  the  extent  to  which  this 
preference  may  be  exercised  there  is  a  very  great  variety  of 
methods,  dividing  preferred  stocks  generally  into  four  classes, 
to  wit:  participating  and  non-participating,  cumulative  and 
non-cumulative. 

Where  the  inherent  nature  of  capital  stock  has  not  been 
modified  by  statute,  and  the  securities  really  represent  shares 
in  proprietorship,  there  can  be  no  valid  provisions  binding  the 
corporation  itself,  absolutely  and  irrespective  of  earnings,  to 
pay  dividends  at  a  stipulated  rate. 

§54.     (i)  Participating  and  Non-participating 

Where  shares  of  stock  are  preferred  as  to  dividends,  a  rate 
per  cent  is  stipulated  which  must  be  paid  before  the  subordinate 
classes  may  share  in  the  profits.  If  the  preferred  stock  is 
limited  to  this  stipulated  rate  it  is  non-participating;  that  is, 
dividends  at  the  stipulated  rate  having  been  paid  out  of  the 
profits  for  a  certain  period,  the  preferred  stock  has  no  further 
claim  upon  the  profits  for  that  period.  If  the  preferred  stock 
is  not  limited  to  the  stipulated  rate  but  may  share  further  in 
the  distribution  of  dividends,  it  is  participating. 

The  terms  according  to  which  participating  preferred 
stocks  may  share  in  the  distribution  of  profits  beyond  the 
stipulated  rate,  vary  greatly.  For  instance,  the  preferred  may 
be  entitled  to  6  per  cent  or  some  other  rate  in  preference  to 
the  common,  then  the  common  will  be  entitled  to  a  like  or 
possibly  a  different  rate  (say,  5  per  cent)  ;  if  there  are  any 
remaining  profits  available  for  distribution  after  both  classes 
have  shared,  the  preferred  will  be  entitled  to  3  per  cent  more, 
then  the  common  may  take  3  per  cent  more,  or  both  classes 
may  share  equally  beyond  the  first  rate  stipulated  on  the  pre- 
ferred.    Or  there  may  be  other  conditions;  for  instance,  that 


I02  CAPITAL    STOCKS 

for  a  period  of  five  years  the  rate  shall  be  5  per  cent,  there- 
after 6  per  cent;  or  that  the  increase  in  the  rate  shall  be  con- 
tingent, to  be  fixed  at  5  per  cent,  for  example,  increasing  to  6 
per  cent  whenever  the  common  stock  is  itself  placed  on  a  6  per 
cent  basis,  or  in  another  instance,  after  the  common  stock 
shall  have  for  two  years  received  dividends' at  the  rate  of  5 
per  cent,  etc. 

The  stipulated  rates  of  dividends  on  preferred  stock  range 
from  4  to  8  per  cent.  A  few  states  have  prescribed  maximum 
rates  of  dividends ;  Wisconsin,  for  instance,  limits  the  prefer- 
ment on  stocks  of  public  service  corporations  to  8  per  cent. 

In  applying  to  the  New  York  Public  Service  Commission 
(Second  District)  for  authority  to  issue  $250,000  of  8  per 
cent  cumulative  preferred  stock,  the  Newburgh  Light,  Heat 
and  Power  Company  set  forth  that  it  could  not  under  the 
then  prevailing  market  conditions  (1907)  borrow  money  or 
sell  its  stock  under  a  dividend  rate  of  less  than  8  per  cent. 
The  Commission  denied  the  application,  saying  that  even  if 
the  contentions  were  accepted  as  entirely  meritorious,  "the 
order  applied  for  should  not,  in  our  opinion,  be  entered.  An 
issue  of  $250,000  8  per  cent  cumulative  preferred  stock  would 
create  a  permanent  annual  charge  of  $20,000  upon  the  prop- 
erty, and,  in  our  judgment,  allowance  of  a  permanent  fixed 
charge  of  this  character  to  meet  temporary  exigencies  of  the 
money  market  is  not  justified.  The  distinction  between  a  con- 
tinuing capital  burden  of  that  description  and  an  issue  of 
bonds  or  notes  for  a  short  term  bearing  a  fair  rate  of  interest, 
even  if  sold  at  a  moderate  discount,  is  obvious.  Favorable 
action  upon  this  petition  would  constitute  a  precedent  which, 
if  followed  in  other  cases,  might  operate  disastrously  to  minor- 
ity stockholders,  and  also  work  hardship  upon  affected  com- 
munities through  the  continuous  necessity  for  service  rates  or 
charges  sufficiently  high  to  meet  such  permanent  obliga- 
tions." '    Upon  a  subsequent  application  the  issue  of  8  per  cent 

'  Matter  of  Newburgh  Lt.,  Ht.  and  Pr.  Co.,  i  P.  S.  C.  Rep.  (^nd  D.,  N.  Y.)  7. 


CLASSIFICATION   OF  CAPITAL  STOCK 


103 


debenture  bonds  to  be  issued  at  par,  and  convertible  after 
two  years  for  common  capital  stock,  was  authorized. 

§  55-     (2)  Cumulative  and  Non-cumulative 

Both  participating  and  non-participating  preferred  stocks 
are  either  cumulative  or  non-cumulative.  Preferred  stock  is 
said  to  be  cumulative  when  the  contract  provides  that  dividends 
not  paid  when  due,  or  the  deficiency  remaining  after  the  pay- 
ment of  a  dividend  at  less  than  the  fixed  rate,  shall  remain  an 
obligation,  as  far  as  the  common  stock  is  concerned,  until  paid. 
Past-due  dividends  on  cumulative  preferred  stock  must  be  paid 
before  the  common  stockholders  may  receive  any  dividend. 
Non-cumulative  preferred  stock  may  have  its  dividend  passed 
without  there  remaining  any  obligation  to  pay  in  the  future. 

A  cumulative  dividend  deficiency  remaining  unpaid  pend- 
ing the  accumulation  of  sufficient  profits,  or  for  some  other 
reason,  does  not  earn  interest.  But  should  the  deficiency  arise 
from  the  wilful  diversion  to  subordinate  classes  of  stock  of 
surplus  profits  properly  available  for  the  payment  of  divi- 
dends, interest  probably  could  be  recovered  as  part  of  the  dam- 
ages for  the  fraudulent  or  wrongful  act. 

Although  a  cumulative  dividend  deficiency  becomes  a 
charge  against  the  profits  of  succeeding  years,  dividends  paid 
in  one  period  in  excess  of  the  stipulated  rate  cannot  be  credited 
against  the  deficiency  of  a  future  period. 

The  issue  of  cumulative  preferred  stocks  may  detract  from 
the  value  of  subordinate  issues,  since  it  lessens  the  prospect  or 
limits  the  amount  of  dividends  apportionable  to  them.  A 
number  of  "passed"  dividends  may  become  such  an  enormous 
charge  upon  the  future  earnings  of  the  company  as  to  render 
the  common  stock  practically  worthless.  A  good  illustration 
of  this  is  found  in  7  per  cent  cumulative  preferred  stock  issue 
of  the  Rutland  Railroad  Company,  the  accumulated  dividends 
on  which  are  said  to  aggregate  over  235  per  cent;  obviously, 
in  the  absence  of  a  financial  rearrangement,  the  common  stock 


I04 


CAPITAL    STOCKS 


of  the  company  (of  which  there  is  a  very  small  amount  out- 
standing, i.e.,  $199,000  against  $9,000,000  of  preferred)  has 
no  chance  of  earning  dividends  although  the  stock  continues  to 
have  some  value  and  its  voting  control  remains  undiminished. 
There  is  danger  in  such  a  situation,  for  the  value  of  the  stock 
may  shrink  so  much  that  it  may  easily  accumulate  in  the 
hands  of  one  or  a  group  of  persons  who  may  be  more  inter- 
ested in  manipulating  the  corporate  affairs  for  a  speculative 
increase  in  value  of  their  holdings  than  in  the  permanent  im- 
provement of  the  corporate  finances. 

On  the  other  hand,  the  "non-cumulative"  feature  may 
allow  the  common  stockholders,  through  their  officers,  to  delay 
the  payment  of  dividends  on  preferred  until  a  surplus  has  been 
accjuired  by  the  company  sufficient  in  amount  to  enable  the 
common  stockholders  to  participate  also  in  its  distribution; 
or,  the  representatives  of  the  common  stock  may  continue  to 
apply  the  profits  to  improvements  until  the  industry  shall  be- 
come so  highly  profitable  through  added  capital  that  the  regu- 
lar return  to  the  common  stock  may  far  exceed  that  fixed  for 
the  preferred. 

§  56.     Preferment  in  Control 

A  right  to  share  in  control  attaches  to  every  share  of  stock 
representing  proprietorship.  The  measure  of  the  right  and 
the  conditions  under  which  it  may  be  exercised  can  be  made 
a  matter  of  agreement;  if  some  shares  surrender  or  delimit 
their  own  rights  there  will  be  created  a  preferment  in  certain 
other  shares.  It  would  be  an  extraordinary  situation  to  find 
one  class  of  capital  stock  preferred  over  another  solely  in  the 
matter  of  voting  rights;  inec|uality  in  the  relative  rights  of 
shares  in  this  respect  is  ordinarily  to  be  found  when  the  stock 
has  been  classified  on  some  other  basis  causing  the  issue  of 
preferred  and  common  shares,  and  the  superior  voting  rights 
may  be  vested  either  in  the  preferred  stock  or  in  the  common 
stock 


CLASSIFICATION    OF    CAPITAL    STOCK 


105 


Preferment  in  voting  rights  is  not  a  necessary  incident  of 
preferred  stocks;  it  cannot  even  be  said  to  be  a  common  in- 
cident. Such  preferment  is  granted  where  the  then  existing 
stockholders  cannot  secure  the  added  capital  necessary  for  the 
enterprise  without  relinquishing  in  favor  of  the  preferred 
stockholders  such  a  portion  of  their  controlling  power  in  gen- 
eral or  in  specific  matters  as  will  enable  the  preferred  stock- 
holders adequately  to  protect  their  investment.  It  must  be 
remembered  that  the  classification  of  stock  means  the  intro- 
duction of  divergent  interests  participating  in  control,  each 
exercising  its  voting  power  to  protect  or  strengthen  its  own 
investment.  For  example,  if  in  addition  to  the  common  there 
is  outstanding  preferred  cumulative,  non-participating,  7  per 
cent  stock,  which  earns  its  dividends  regularly  while  the  com- 
mon stock  is  able  to  earn  only  3  per  cent,  the  preferred  stock- 
holders will  seek  to  conserve  their  interests  by  maintaining 
the  operating  status,  while  the  common  stockholders  will  be 
anxious  to  extend  operations  even  at  the  cost  of  greater  hazard, 
if  there  is  the  least  probability  of  increased  returns  upon  their 
holdings.  Of  course,  under  a  classification  such  as  that  cited, 
the  interests  of  the  two  might  sometimes  coincide;  for  in- 
stance, if  neither  class  were  earning  the  expected  dividends. 
If  voting  rights  of  preferred  and  common  stock  are  equal, 
and  there  are  a  much  larger  number  of  shares  of  common  than 
preferred  stock  outstanding,  the  common  stockholders  might 
become  firmly  intrenched  in  control.  In  such  a  case  preferred 
stockholders  will  demand  actual  preferment  in  voting  rights  so 
as  to  protect  their  own  position. 

Preference  in  voting  rights  may  be  general,  specific,  or 
contingent.  General  preference  exists  where  preferred  stock  is 
actually  given  a  greater  voting  right  per  share  than  the  com- 
mon, e.g.,  one  vote  for  each  share  of  preferred  as  against  one 
vote  for  two  shares  of  common.  Such  general  preference 
may  have  a  contingent  limitation ;  for  instance,  control  may  be 
vested  in  the  preferred  stock  until  such  time  as  the  preferred 


I06  CAPITAL   STOCKS 

shall  have  received  6  per  cent  per  annum  for  three  consecutive 
years,  and  thereafter  the  rights  of  the  preferred  and  common 
shares  will  be  equal. 

Specific  preference  vests  in  the  preferred  stock  greater  vot- 
ing power  than  is  possessed  by  the  common,  to  be  exercised 
only  in  respect  of  certain  specified  corporate  acts.  An  in- 
stance of  a  very  broad  grant  of  such  preference,  almost 
amounting  to  general  preference,  is  that  vesting  in  preferred 
stock  the  right  to  elect  a  majority  of  the  board  of  directors. 
Most  cases  of  specific  preference  really  amount  to  a  veto 
power  over  the  action  of  the  common  stockholders,  a  very 
usual  condition  being  the  limitation  upon  the  power  of  the 
common  stockholders  to  authorize  an  increase  in  the  amount 
of  preferred  stock  or  an  increase  in  bonds  over  a  certain 
amount.  It  may  be  that  two-thirds  of  the  outstanding  pre- 
ferred stock  will  be  required  to  consent  to  any  increase  in 
preferred  stock  or  any  new  mortgage,  while  of  common  stock 
only  the  majority  vote  of  the  amounts  represented  at  a  meet- 
ing may  be  necessary. 

Stock  which  cannot  exercise  superior  voting  power  until 
a  certain  event  occurs  or  a  special  situation  develops,  is  sub- 
ject to  contingent  preference.  An  example  of  contingent 
specific  preferment  is  the  right  of  preferred  stockholders  to 
elect  a  majority  of  the  directors  should  the  company  fail  for 
two  successive  years  to  earn  and  pay  dividends  at  the  stipu- 
lated rate. 

Where  greater  voting  power  is  lodged  in  the  preferred 
stock  it  is  because  a  like  amount  of  power  has  been  given  up  by 
the  common  stockholders  in  consideration  of  the  assurance  of 
capital.  The  contrary  situation  also  arises,  however,  and 
greater  voting  power  may  be  vested  in  the  common  stock  at 
the  expense  of  the  preferred,  the  waiver  by  the  latter  being  in 
consideration  of  an  assured  specific  income.  There  seems  to 
be  nothing  in  the  court  decisions  or  in  text-books  to  indicate 
that  this  waiver  may  not  be  an  absolute  one,  but  the  writer's 


CLASSIFICATION   OF   CAPITAL   STOCK  107 

Opinion  is  that  it  cannot  be  made  so,  and  that  upon  certain 
contingencies,  such  as  apparent  mismanagement  jeopardizing 
the  rights  or  diverting  the  profits,  equity  will  restore  to  the 
preferred  stockholders  so  much  of  the  power  which  they  had 
surrendered  as  may  be  necessary  to  safeguard  their  interests. 
In  many  cases  this  waiver  is  not  absolute  in  its  terms  but  re- 
linquishes rights  in  some  matters  and  reserves  them  in  others. 
For  instance,  the  consent  of  stock  otherwise  having  no  general 
voting  rights  may  be  necessary  to  the  issuing  of  any  new 
mortgage,  or  to  create  any  other  preference,  or  to  dissolve  the 
corporation. 

If  by  its  terms  the  waiver  is  conditional  upon  the  per- 
formance of  certain  acts,  such  as  the  regular  payment  of  divi- 
dends, failure  to  perform  those  acts  will  return  control  to  the 
preferred  stockholders. 

Preferred  stock  without  voting  power  is  sometimes  issued 
where  control  is  sought  to  be  centered  in  one  group.  For  such 
a  purpose  this  device  may  be  preferable  to  the  issue  of  bonds, 
either  because  of  readier  sale,  or  because  it  eliminates  the  pos- 
sibility of  the  controlling  group  being  ousted  through  fore- 
closure of  mortgage. 

§  57.     Convertible  Preferred  Stock 

Sometimes  preferred  stock  of  one  class  is  made  con- 
vertible at  the  option  of  the  holder  into  common  or  other 
subordinate  issue  of  stock  or  into  bonds.  This  privilege  of 
conversion  may  be  exercised  immediately,  or  after  a  certain 
date,  or  within  a  certain  period,  and  the  conversion  may  be 
effected  at  par  of  the  securities  for  which  converted  or  in  other 
proportions. 

A  right  of  conversion  into  common  stock  is  most  valuable 
if  it  accompanies  non-participating  stocks  carrying  a  low  rate 
of  dividends  (say,  4  per  cent) ;  should  the  profits  of  the  com- 
pany be  sufficient  to  pay  a  higher  rate  (say,  8  per  cent)  regu- 
larly on  the  common  stock,  the  preferred  shares  can  with  ad- 


Io8  CAPITAL   STOCKS 

vantage  be  converted  into  common.  Note,  for  instance,  that 
the  common  stock  of  the  Union  Pacific  Railroad  Company 
ever  since  the  spring  of  1904  has  sold  at  higher  prices  than 
the  4  per  cent  non-participating  preferred  stock ;  the  highest 
quotation  for  the  preferred  has  been  118,  while  the  common 
once  reached  219.  The  right  may  also  become  valuable  in 
the  case  of  preferred  stock  with  limited  voting  power.  If  it 
should  appear  that  the  attitude  of  those  in  control  is  inimical 
to  the  interests  of  the  preferred  holders,  the  latter  could  con- 
vert their  holdings  into  voting  shares  and  themselves  assume 
control,  provided  their  aggregate  holdings  were  sufficient. 

The  use  of  conversion  privileges  is  better  known  in  con- 
nection with  bonds  and  is  discussed  in  that  connection  (§  120). 
Bonds  convertible  into  stock  have  been  issued  frequently;  in- 
stances of  stocks  convertible  into  bonds  are  also  to  be  found, 
however.  The  4  per  cent  non-cumulative  second  preferred 
stock  of  the  Reading  Company,  which  after  dividends  at  4  per 
cent  have  been  paid  for  two  consecutive  years  may  be  con- 
verted at  the  option  of  the  company  at  par,  one-half  into  first 
preferred  and  one-half  into  common,  is  an  interesting  example 
of  convertible  stock.  The  conversion  being  at  the  option  of 
the  company,  this  stock  is  more  correctly  described  as  redeem- 
able, falling  within  the  class  referred  to  below. 

§  58.     Redeemable  Preferred  Stock 

Some  preferred  stocks  are  made  callable,  or  redeemable,  at 
the  option  of  the  corporation  to  be  exercised  under  stipulated 
conditions  as  to  manner  and  time.  Considerations  applying 
to  the  redemption  of  preferred  stock  are  very  similar  to  those 
which  apply  to  the  redemption  of  bonds  (see  Chapter  XI), 
and  similarly  the  option  may  be  exercised  at  any  time,  or  after 
a  certain  date,  or  within  a  certain  period;  often,  also,  a 
premium  is  paid  upon  redemption.  The  option  of  redemption 
has  very  frequently  been  reserved  by  railroad  corporations 
issuing  preferred  stocks. 


CLASSIFICATION   OF   CAPITAL   STOCK  109 

A  famous  instance  of  the  use  of  the  right  of  redemption 
was  that  incidental  to  the  contest  in  1901  between  the  Harri- 
man  and  the  Hill  interests  for  the  control  of  the  Northern 
Pacific  Railroad.  At  the  height  of  the  contest,  the  Harriman- 
Kuhn,  Loeb  Syndicate  owned  $37,000,000  of  the  outstanding 
$80,000,000  common  stock,  and  $42,000,000  of  the  $75,000,- 
000  preferred  stock — a  total  of  $79,000,000  which  repre- 
sented a  clear  majority  of  all  the  outstanding  stock.  The  Hill 
interests  acquired  $42,000,000  of  the  common  stock,  repre- 
senting a  majority  of  $2,000,000  of  the  common  stock  only. 
The  preferred  possessed  the  same  voting  power  as  the  com- 
mon, but  was  subject  to  redemption  at  par  up  to  January, 
1912.  The  Hill  interests  controlling  a  majority  of  the  com- 
mon stock  announced  their  intention  of  exercising  the  option 
and  accordingly  redeemed  all  the  preferred,  thereby  acquiring 
absolute  control.  The  Harriman  group  succeeded  in  getting 
only  one  representative  on  the  board  of  directors. 

§  59-    Special  Classes  of  Stocks 

There  are  a  great  number  of  special  classes  of  capital 
stock  which  take  their  names  from  special  attributes  attaching 
to  them.  It  is  unnecessary  to  note  all  of  these ;  the  citation  of 
a  few  of  the  more  important  ones  will  be  sufficient. 

Interest-bearing  Stock.  Reference  to  this  class  of  stock 
can  be  found  in  some  of  the  older  discussions  of  railroad 
finance;  it  is  now  practically  obsolete.  Interest-bearing  stock 
was  issued  in  lieu  of  preferred  stock  and  it  consisted  of  the 
ordinary  common  stock  issued  under  an  agreement  that  the 
corporation  would  pay  interest  thereon  during  the  period  when 
its  railroad  remained  under  construction,  for  instance,  or  until 
it  was  placed  in  operation.  Although  the  promise  was  that  of 
paying  "interest,"  it  was  construed  by  the  courts  to  be  a 
promise  to  pay  out  of  profits,  for  otherwise  the  agreement 
would  fail  by  reason  of  being  against  public  policy.  The  title 
"interest-bearing"  is  therefore  inaccurate;  the  return  prom- 


no  CAPITAL    STOCKS 

ised  is  really  a  cumulative  dividend,  the  accumulation  to  cease 
upon  the  happening  of  the  specified  and  contemplated  event, 
and  payment  of  the  amount  to  become  due  in  whole  or  in 
part  as  the  company  became  possessed  of  sufficient  accumulated 
profits  to  pay  part  or  the  whole.  The  accumulated  amount 
must  be  discharged  in  full  before  dividends  can  be  declared 
upon  other  classes  of  stock.  The  sole  purpose  of  the  ex- 
pedient was  that  of  offering  an  incentive  to  investors  in  order 
to  attract  capital  during  a  period  of  construction  when  in  the 
nature  of  things  no  profits  could  be  earned.  Authority  for 
the  issue  of  capital  stock  of  this  class  is  still  to  be  found  upon 
the  Massachusetts  statute  books. 

Special  Stock.  The  issue  of  special  stock,  so  called,  is 
provided  for  by  the  Massachusetts  laws.  It  is  described  as  "a 
peculiar  kind  of  stock,  distinctly  provided  for  by  statute,"  ^  and 
sharply  distinguished  from  preferred  stock.  "Its  characteris- 
tics are  that  it  is  limited  in  amount  to  two-fifths  of  the  actual 
capital;  it  is  subject  to  redemption  by  the  corporation  at  par 
after  a  fixed  time,  to  be  expressed  in  the  certificates;  the  cor- 
poration is  bound  to  pay  a  fixed  sum  as  dividends ;  the  holders 
of  it  are  in  no  event  liable  for  the  debts  of  the  corporation 
beyond  their  stock,  and  the  issue  of  special  stock  makes  all  the 
general  stockholders  liable  for  all  the  debts  and  contracts  of 
the  corporation  until  the  special  stock  is  fully  redeemed." 

Founders'  Shares.  Shares  of  this  class  were  never  re- 
ceived with  favor  in  this  country  and  probably  have  not  been 
used  for  many  years.  Even  in  England,  where  it  originated, 
stock  of  this  nature  appears  now  to  be  but  little  used.  Its 
function  was  that  of  securing  to  the  promoters  control  of  the 
business  and  the  largest  measure  of  profits  if  the  enterprise 
became  successful.  The  common  or  preferred  stocks  were  first 
to  share  in  the  available  profits  up  to,  say,  7  to  9  and  10  per 
cent,  after  which  holders  of  founders'  shares  were  entitled  to 
take  one-third  to  one-half  of  the  remaining  profit.    Founders' 

^American  Tube  Works  v.  Boston  Machine  Co.,  139  Mass.  5. 


CLASSIFICATION    OF   CAPITAL   STOCK  m 

shares  usually  were  a  small  percentage  of  the  total  capital 
stock. 

Debenture  Stock.  This  also  is  an  English  term,  and  it  re- 
lates to  a  debt  of  the  company  and  not  to  an  interest  in  the 
proprietorship  thereof.  The  word  "stock"  as  here  used  is  not 
synonymous  with  the  like  word  in  such  terms  as  "common 
stock,"  "preferred  stock,"  and  "stock,"  etc.  English  corpora- 
tion finance  uses  the  terms  "shares"  and  "stock"  in  a  sense 
which  differs  from  ours.  The  capital  of  the  company  is 
divided  into  shares  of  a  certain  number  and  amount;  these 
shares  are,  in  fact,  shares  of  stock  as  we  have  them.  The 
company  may  then  convert  paid-up  shares  into  a  general 
capital  stock  to  be  divided  among  the  shareholders  in  propor- 
tion to  their  respective  interests  therein ;  in  other  words,  capi- 
tal stock  is  the  aggregate  of  shares,  and  similarly  "debenture 
stock"  is  the  aggregate  of  debentures.  Shares  are  dealt  in  ac- 
cording to  their  specific  denominations,  which  are  most  com- 
monly £i  and  £5.  Stock  can  be  dealt  in  and  transferred  in 
fractional  parts,  usually  in  multiples  of  one  pound,  but  some- 
times even  less.     (See  also  §  102.) 


CHAPTER   VII 

DIVIDENDS 

§  60.    Declaration  of  Dividends 

A  dividend  is  "a  portion  of  the  principal  or  profits  divided 
among  the  several  owners  of  a  thing."  ^  Thus,  the  distribu- 
tion of  assets  upon  the  dissolution  of  a  corporation,  or  the 
settlement  of  a  bankrupt's  estate,  is  spoken  of  as  the  payment 
of  dividends.  In  corporation  finance  its  ordinary  use  relates 
to  the  distribution  of  profits  among  the  stockholders. 

A  dividend  is  declared  when  an  amount  is  set  aside  out 
of  the  net  profits  as  a  fund  to  be  divided  equally  among  the 
shares  of  stock  and  to  be  paid  to  stockholders  in  proportion 
to  their  holdings.  The  declaration  must  be  made  by  the  direc- 
tors, who,  at  the  time  of  declaration,  prescribe  the  conditions 
under  which  and  the  times  at  which  they  shall  be  payable  to  the 
stockholders.  The  directors  alone  have  this  power  and  they 
may  exercise  it  in  their  discretion;  their  judgment  alone 
governs.  In  effect,  the  declaration  and  payment  of  dividends 
constitutes  a  parting  with  some  of  the  corporate  assets,  and  it 
should  be  authorized  by  formal  and  specific  action  of  the 
board  of  directors — who  are  the  trustees  of  the  corporate 
property — at  a  meeting  lawfully  and  regularly  assembled.  If 
it  were  permissible  to  declare  dividends  without  such  a  meeting 
of  directors  to  afford  opportunity  for  deliberation  and  inter- 
change of  opinion,  and  to  place  upon  record  the  details  of  the 
action  taken,  the  interests  of  the  stockholders  or  of  some  of 
them  might  be  jeopardized.  There  are  other  countries  where 
the  shareholders  have  a  more  immediate  control  over  the 
declaration  of  dividends,  which  are  declared  at  general  stock- 


*  Bouvier's  Law  Dictionary. 

112 


DIVIDENDS  113 

holders*  meetings  when  reports  of  directors  and  officers  are 
heard  and  acted  upon.  The  better  method,  however,  is  un- 
doubtedly that  of  placing  the  responsibility  solely  upon  the 
directors  and  holding  them  strictly  to  the  duties  of  their 
trusteeship.  Shareholders  too  often  look  to  the  present  alone 
and  consider  their  own  interests,  while  they  lack  the  inti- 
mate knowledge  of  corporate  affairs  which  would  enable 
them  to  act  with  as  much  wisdom  and  prudence  as  the 
directors. 

§  61.    Dividends  Out  of  Surplus  Profits 

It  is  a  general  rule  that  dividends  must  be  paid  only  out 
of  surplus  profits.  The  very  definition  of  the  term  implies  it. 
The  New  York  Stock  Corporation  Law  prohibits  the  declar- 
ing of,  and  the  Penal  Law  makes  it  a  misdemeanor  to  de- 
clare, dividends  except  from  the  surplus  profits  arising  from 
the  business  of  such  corporation,  or  to  "divide,  withdraw,  or 
in  any  way  pay  to  the  stockholders  or  any  of  them,  any  part 
of  the  capital  stock  of  such  corporation  or  reduce  its  capital 
stock,  except  as  authorized  by  law." 

To  say  that  dividends  must  be  paid  out  of  profits  is  to  say 
that  they  must  not  be  paid  out  of  capital.  Those  who  ad- 
vanced the  means  of  acquiring  that  capital,  whether  through 
purchase  of  stock  or  bonds,  were  investing  in  an  enterprise 
which  seemed  to  afford  opportunities  for  profit;  they  were 
not  merely  making  a  deposit  with  the  company.  They  may 
rightfully  expect,  therefore,  that  the  entire  capital  shall  con- 
tinue to  be  devoted  to  the  operations  for  which  it  was  intended, 
except,  of  course,  as  losses  may  make  inroads  therein.  Any 
diversion  of  the  capital  to  any  other  purpose  whatever  will 
prejudice  the  rights  of  both  shareholders  and  creditors,  as 
well  as  of  the  public  which  is  dependent  upon  the  service. 

The  exercise  of  care  to  prevent  the  diversion  of  capital  to 
the  payment  of  dividends  is  necessary  for  the  protection  of 
all  parties  dealing  with   or   interested   in   the   corporation. 


114 


CAPITAL   STOCKS 


Where  a  corporation  has  issued  some  of  its  shares  of  capital 
stock  to  bona-fide  purchasers  for  value  and  other  shares  in 
exchange  for  property  or  services  grossly  overvalued,  the  di- 
vision of  capital  in  the  guise  of  dividends  is  tantamount  to 
dividing  part  of  the  money  of  the  bona-fide  stockholders 
among  the  others.  The  favored  stockholders  may  thus  make  a 
considerable  profit  resulting  not  at  all  from  the  operation  of 
the  corporate  enterprise,  but  rather  through  the  perversion  of 
the  corporate  object.  Or,  instead  of  one  group  of  stock- 
holders profiting  out  of  the  losses  of  another  group,  the  entire 
body  of  stockholders  may  be  thus  favored  at  the  expense  of 
bondholders;  the  continued  apportionment  of  capital  as  divi- 
dends will  lead  to  bankruptcy,  and  the  creditor  or  bondholder 
who  thought  his  claim  was  amply  secured  will  find  that  his 
money  has  been  transferred  to  the  stockholders,  that  the 
security  has  been  dissipated,  and  that  he  has  been  remanded 
to  a  lien  on  a  depreciated,  worn-out,  and  obsolete  plant.  It 
is  well  to  note  that  precisely  this  situation  has  often  developed 
through  poor  accounting  where  there  has  been  no  wilful  pur- 
pose and  the  intentions  of  the  management  have  been  most 
worthy.  If  the  corporation  is  engaged  in  public  service,  the 
community,  of  course,  will  either  lose  the  service  altogether  or 
else  will  have  to  get  along  with  the  poor  service  possible 
under  such  circumstances. 

In  the  United  States,  statutory  regulation  of  dividend  dis- 
tribution has  been  notable  mainly  for  the  absence  of  definite 
provisions,  and  public  service  commissions  themselves  have  not 
been  accorded  specific  powers  in  this  respect;  legislators  have 
been  reluctant  to  deal  with  this  part  of  corporate  finance,  and, 
without  question,  they  have  thus  followed  the  wisest  course 
pending  the  standardization  of  accounting  procedure.  In  some 
other  countries  the  subject  has  received  more  consideration. 
We  have  already  referred  to  the  German  Commercial  Code 
which  makes  detailed  provision  for  the  preparation  of  the 
annual  balance  sheet,  directing  the  basis  upon  which  inventory 


DIVIDENDS 


115 


shall  be  taken  (at  market  value,  if  available,  or  else  at  a  value 
not  exceeding  cost).  A  very  interesting  part  of  this  Code  is 
that  which  attempts  to  provide  for  the  permanency  of  divi- 
dends by  requiring  certain  reserve  funds  to  be  kept.  It  is  high 
time  that  the  public  here  realized  that  regularity  and  adequacy 
in  payment  of  dividends  on  the  invested  capital  of  stock- 
holders is  just  as  much  a  matter  of  public  interest  and  benefit 
as  the  payment  of  principal  or  interest  on  bonds,  or  the  prompt 
payment  of  any  commercial  or  banking  obligation. 

§  62.     Determination  of  Surplus 

The  determination  of  what  constitutes  surplus  profits 
properly  apportionable  as  dividends  is  a  difficult  matter  and 
goes  deeply  into  accounting  theory  and  practice.  Surplus  is 
the  excess  of  assets  over  liabilities;  the  contrary  situation — 
an  excess  of  liabilities  over  assets — denotes  a  deficit.  A  state- 
ment summing  up  the  assets  and  liabilities  at  any  one  time  is 
the  balance  sheet  of  the  business.  This  balance  sheet  could  be 
constructed  in  either  one  of  two  ways: 

First,  by  assembling  all  the  assets,  i.e.,  the  values  of  the 
different  elements  of  the  corporation's  property  and  the 
amounts  of  its  collectible  and  valid  accounts  or  other  claims, 
and  then  all  the  liabilities,  i.e.,  the  amount  of  its  various  money 
obligations  (including  the  nominal  liability  on  capital  stock). 
This  is  the  inventory  method  and  is  the  foundation  of  all  ac- 
counting systems. 

Second,  a  balance  sheet  having  been  once  prepared,  another 
one  for  a  later  date  may  be  constructed  by  tracing  through  the 
accounts  and  records  of  the  business  the  changes  of  values 
since  the  date  of  the  last  preceding  balance  sheet,  summarizing 
the  net  balances  affecting  the  assets  on  the  one  hand,  and  the 
obligations  on  the  other.  This  method  comprehends  the 
whole  system  of  corporate  accounting. 

The  inventory  method  as  a  continuing  practice  is  possible 
only  in  the  case  of  a  very  small  business  or  under  exceptional 


Il6  CAPITAL  STOCKS 

circumstances;  in  the  case  of  large  corporations  it  involves 
costs  so  heavy  and  labor  so  considerable  as  to  be  justifiable 
only  on  rare  occasions  and  for  special  purposes,  hence  the 
necessity  of  correct  accounting  as  a  part  of  corporate  finance. 

§  63.     (i)  Importance  of  Correct  Accounting 

There  are  many  corporations  today  which  have  never  kept 
their  books  in  such  a  way  that  a  correct  statement  of  assets 
and  liabilities  can  be  drawn  from  them;  their  true  financial 
status  is  therefore  not  known  to  the  stockholders.  Such  a 
corporation  may  go  on  for  years  showing  apparent  profits  and 
distributing  dividends,  while  it  is,  as  a  matter  of  fact,  accumu- 
lating a  deficit  instead,  so  that  some,  at  least,  of  dividend 
payments  made  during  the  interim  were  apportionments  of 
capital  and  not  of  profits.  The  interests  of  stockholders, 
creditors,  and  the  community  are  in  jeopardy  where  this  situa- 
tion obtains,  even  though  it  may  have  arisen  wholly  out  of 
ignorance  and  without  the  slightest  intention  to  deceive.  It 
becomes  much  more  serious  in  its  possibilities  where  expert 
accountants  and  an  elaborate  accounting  system  apparently 
capable  of  a  correct  showing  are  intentionally  used  so  as  to 
misrepresent  the  financial  condition  of  the  corporation.  The 
aim  and  purpose  of  a  great  deal  of  work  done  by  regulating 
commissions  in  prescribing  uniform  accounting  systems  and 
requiring  other  corporate  records  to  be  kept  has  been  that  of 
assisting  corporations  to  understand  their  own  affairs  better, 
and  by  the  formulation  of  uniform  practices  to  minimize  the 
possibility  of  misstatement. 

§  64.  (2)  Balance  Sheet,  Income  Statement,  and  Profit  and 
Loss  Account 
The  balance  sheet  shows  the  financial  status  of  the  cor- 
poration as  of  a  particular  instant;  if  it  portrays  the  status  of 
an  operating  corporation  its  representations  will  be  modified 
by  the  result  of  operations  even  before  all  of  the  figures  have 


DIVIDENDS 


117 


been  summarized  and  written  down.  A  balance  sheet  might 
be  made  up  for  each  day,  and  each  one  would  differ  from  all 
the  others.  A  statement  of  the  results  of  operations  is  there- 
fore a  necessary  adjunct  of  each  balance  sheet  to  indicate  the 
causes  which  have  brought  about  the  changes  in  assets  or 
liabilities,  or  which,  in  other  words,  have  produced  the  present 
figure  of  corporate  profit  or  loss.  This  statement  is  the  In- 
come account  of  the  corporation;  it  is  usually  made  up  on  a 
yearly  basis  and  it  includes  the  revenue  accounts,  the  revenue 
deduction  accounts,  i.e.,  the  operating  expenses,  taxes,  and 
uncollectible  bills,  and  the  income  deduction  accounts,  i.e., 
fixed  charges  of  interest,  rents,  and  other  contractual  pay- 
ments. Its  ultimate  figure  is  the  net  corporate  income — the 
excess  of  total  income  over  total  deductions,  or  the  net  cor- 
porate loss — the  excess  of  total  deductions  over  total  income. 

The  net  corporate  income  or  the  net  corporate  loss  adds 
to  the  accumulated  surplus  or  deficit.  That  surplus  or  deficit, 
however,  is  itself  subject  to  adjustments  through  gains  (e.g., 
gifts,  profit  realized  upon  the  sale  of  investments,  etc.)  or 
losses  (e.g.,  losses  suffered  upon  the  sale  of  investments,  ex- 
traordinary casualties,  and  dividends  which  draw  from  sur- 
plus) ;  these  are  items  which  cannot  be  said  to  constitute  in- 
come or  deductions  from  the  income  or  which  are  in  adjust- 
ment of  the  net  corporate  income  of  a  prior  period  since 
merged  in  the  total  corporate  deficit  or  surplus.  These  changes 
in  the  amount  of  surplus  or  deficit  are  recorded  in  a  Corporate 
Surplus  or  Deficit  account,  better  known  by  its  time-honored 
designation  of  the  "Profit  and  Loss"  account.^ 

There  are,  then,  three  groups  of  accounts  among  which  no 
confusion  should  occur,  for  each  represents  a  separate  class  of 

'  In  the  enumeration  of  items  to  be  included  in  the  respective  groups,  the  general 
outline  of  the  Uniform  Systems  of  Accounts  adopted  by  the  Public  Service  Commissions 
of  New  York  and  the  Interstate  Commerce  Commission  has  been  followed.  Con- 
cerning some  of  the  items  there  are  differences  of  opinions  as  to  the  groups  in  which 
they  should  be  entered.  It  must  also  be  noted  that  the  use  of  the  "Profit  and  Loss" 
account  here  described  in  the  practice  of  public  service  corporations  is  very  different 
from  the  practice  of  manufacturing  or  mercantile  corporations  where  the  "Profit  and 
Loss"  account  also  includes  all  the  items  which  here  are  grouped  as  the  Income  ac- 
count, and  itself  does  not  appear  upon  the  balance  sheet  but  is  closed  out  into  an  ac- 
count "Proprietorship." 


Il8  CAPITAL   STOCKS 

facts.  The  balance  sheet  shows  the  facts  of  present  assets  and 
Habilities  and  thus  measures  solvency  as  of  its  date;  the  In- 
come account  shows  how  much  was  made  or  lost  in  the  opera- 
tions of  the  period  covered,  while  the  Profit  and  Loss  account 
takes  up  the  net  corporate  income  or  loss  and  combines  it 
with  the  net  balance  remaining  from  all  operations  prior  to  the 
present  Income  account,  makes  necessary  adjustments,  and 
shows  how  much  of  profit  remains  on  hand,  or  what  is  the 
aggregate  amount  of  loss.  The  last  two  groups  of  accounts 
perform  parts  of  the  one  function  of  explaining  changes  in 
solvency,  indicating  no  subsisting  facts,  however,  all  of  which 
it  is  the  sole  function  of  the  balance  sheet  to  report. 

Confusion  in  classifying  the  items  between  these  accounts, 
if  not  intentionally  brought  about,  arises  most  often  through 
misunderstanding  or  ignorance  of  the  distinction  between  fixed 
and  floating  capital,  of  expenditures  for  betterments,  replace- 
ments, and  renewals  of  capital,  of  the  nature  of  depreciation, 
or  through  errors  in  valuation  of  various  assets.  A  full  dis- 
cussion of  the  proper  methods  of  obviating  these  difficulties  is 
more  appropriate  to  a  treatise  on  accounting  than  it  is  to  a 
study  of  this  kind,  and  only  the  essential  principles  to  be  fol- 
lowed can  be  suggested  herein. 

§  65.     (3)  Real  Surplus  Distinguished  from  Book  Surplus 

Surplus  is  thus  seen  to  be  essentially  a  product  of  the 
balance  sheet,  and  its  proper  determination  becomes  a  question 
of  correctly  stating  the  balance  sheet.  It  was  said  above  that 
the  balance  sheet  measured  the  solvency  of  the  corporation. 
That  was  a  correct  statement  of  its  function,  but  at  the  same 
time  it  was  the  statement  of  an  ideal  rather  than  of  present 
attainment  in  most  cases.  The  measure  of  solvency  is  the 
difference  between  the  actual  available  value  of  the  assets  and 
the  amount  of  the  subsisting  debts  and  claims  owed  by  a  cor- 
poration. A  part  of  this  difference  will  represent  the  original 
investment  of  the  stockholders,  and  if  that  is  deducted,  the  net 


DIVIDENDS  IIQ 

remainder  is  the  amount  of  real  surplus.  If  the  difference  be- 
tween the  value  of  assets  is  less  than  the  allowance  which 
should  be  made  for  original  investment  of  the  stockholders, 
instead  of  surplus  there  is  a  deficit.  It  becomes  necessary, 
therefore,  to  distinguish  between  real  surplus  and  book  surplus 
in  all  cases  where  the  balance  sheet  does  not  or  cannot  show 
the  actual  available  value  of  the  assets,  and  this  it  does  not 
and  in  large  measure  cannot  do  in  the  case  of  public  service 
corporations. 

The  most  important  item  of  assets  of  a  public  service  cor- 
poration is  its  plant,  or  fixed  capital  in  service.  The  manner 
in  which  this  asset  should  be  taken  up  on  the  balance  sheet  is 
discussed  in  Cliapter  XVI,  where  the  conclusion  is  reached 
that  it  is  impracticable,  not  to  say  impossible,  to  carry  this 
asset  at  any  figure  which  could  be  said  to  be  the  actual  avail- 
able value  thereof;  in  the  absence  of  any  better  method,  it  is 
recorded  at  its  original  cost.  Of  course,  as  any  part  of  the 
fixed  capital  is  sold  and  the  value  becomes  known  (the  sale 
price  being  the  value)  and  realized  upon,  the  excess  or  deficit 
of  that  from  cost  will  be  promptly  taken  into  the  accounts  and 
will  pass  into  the  "Corporate  Surplus  or  Deficit"  account. 
The  cost  at  which  fixed  capital  is  carried  on  the  books  may  be 
either  more  or  less  than  the  real  value,  but  the  reader  of  the 
balance  sheet  must  supply  his  own  data  to  arrive  at  the  real 
value,  or  obtain  the  opinion  of  an  expert  analyst.  The  only 
respect  in  which  the  balance  sheet  will  indicate  any  divergence 
from  the  cost  will  be  as  it  reflects  the  allowances  for  the  known 
incidents  of  use  which  operate  to  decrease  values;  for  instance, 
the  wear  and  tear  which  must  be  repaired  and  is  made  good 
through  the  current  operating  expenses,  and  the  irreparable 
wear  and  tear,  the  obsolescence  or  inadequacy,  which  will  in 
time  cause  the  retirement  of  the  capital,  requiring  that  in  the 
meantime  adequate  provision  be  made  against  the  contingency. 
This  most  important  asset,  therefore,  is  seen  to  have  a  book 
value  at  which  it  appears  upon  the  balance  sheet,  and  also  a 


I20  CAPITAL   STOCKS 

real  value  which  does  not  appear  from  any  financial  statement 
drawn  from  the  accounts.  Correspondingly,  there  is  a  book 
surplus  appearing  upon  the  balance  sheet,  and  available  for  the 
purpose  of  dividends,  and  also  a  real  surplus  which  is  not 
currently  available  and  can  be  made  so  only  upon  the  con- 
tingency of  a  sale  of  the  property  or  a  definite  and  authorita- 
tive appraisal  thereof. 

For  many  large  corporations  the  assets  of  greatest  im- 
portance next  to  fixed  capital  are  the  investments.  Invest- 
ments often  depreciate  in  value  rapidly  and  substantially.  If 
their  valuation  were  placed  and  kept  at  original  cost,  the  sur- 
plus might  at  times  be  considerably  overstated  or  understated 
because  of  the  depreciation  or  appreciation  in  value  of  the 
securities  held.  Again,  if  an  attempt  is  made  to  revalue  these 
investments  periodically  upon  the  basis  of  market  prices,  ad- 
justing surplus  to  correspond,  not  only  will  surplus  be  sub- 
jected to  rapid  fluctuations,  but  the  opportunity  may  be  seized 
to  bolster  up  surplus  for  the  distribution  of  dividends.  More- 
over, by  far  the  greater  portion  of  investments  of  public 
service  corporations  are  in  the  stocks  and  bonds  of  subsidiary 
and  controlled  corporations — in  many  cases  the  investment 
comprises  the  whole  issue  of  such  stocks  or  bonds,  so  that 
there  is  not  a  sufficient  part  thereof  upon  the  general  market 
to  determine  values.  Even  if  there  were,  manifestly  the 
values  would  be  determined  to  a  large  extent,  if  not  altogether, 
by  the  operating  policy  and  success  of  the  controlling  corpora- 
tion which  is  also  the  investor,  so  that  it  could  manipulate 
values  for  the  purposes  of  revaluing  its  holdings.  Where 
such  stock  is  held  for  the  purposes  of  control,  obviously  the 
holding  company  is  estopped  from  parting  with  the  stock,  else 
it  would  lose  control ;  the  further  question  arises,  then,  whether 
or  not  a  corporation  holding  such  stock  can  be  said  to  have 
its  investments  increased  in  value  when  it  is  in  no  position 
to  realize  the  appreciation.  Manifestly  no  rule  can  be  formu- 
lated as  to  the  basis  upon  which  investments  shall  be  valued 


DIVIDENDS  121 

for  accounting  purposes,  and  reliance  must  be  placed  upon  the 
honesty  of  the  corporation  in  stating  its  investments  at  a  fair 
valuation.  The  practice  approved  in  official  accounting  orders 
applying  to  public  service  corporations  is  that  investments 
should  be  carried  at  cost,  but  depreciation  may  be  written  off, 
while  the  writing  up  of  appreciation  is  not  usually  allowed. 

§  66.     (4)  Manipulation  of  Surplus 

There  are  a  great  many  ways  in  which  the  balance  of  sur- 
plus may  be  manipulated;  although  at  times  the  purpose  of 
the  manipulation  is  to  secure  understatement,  the  most  fre- 
quent attempts  are  to  secure  overstatement.  When  he  is  con- 
fronted with  a  situation  where  dividends  must  be  paid,  even 
though  earnings  have  been  insufficient,  the  shrewd  financier 
will  invent  innumerable  means  of  developing  an  apparent  sur- 
plus, taking  his  chances  on  future  earnings  making  good  the 
withdrawal  of  capital.  All  of  these  many  forms,  when 
analyzed,  can  be  shown  to  be  either  the  overstatement  of  assets 
and  the  understatement  of  liabilities,  or  the  swelling  of 
revenues  and  shrinking  of  operating  expenses. 

There  can  be  little  opportunity  for  the  manipulation  of 
cash  account  and  of  accounts  or  bills  receivable  records. 
Where,  however,  the  latter  represent  accounts  or  bills  receiv- 
able from  system  corporations  or  related  interests,  both  oppor- 
tunity and  motive  for  manipulation  may  exist  at  times;  it  is 
desirable,  therefore,  that  accounts  and  bills  receivable  from 
system  corporations  should  be  separately  shown  upon  the 
balance  sheet.  Official  forms  for  annual  reports  to  commis- 
sions usually  make  provision  for  the  separate  statement  of  all 
such  items. 

It  is  seldom  that  the  total  amount  of  materials  and  sup- 
plies on  hand  and  not  yet  consumed  in  the  operations  of  public 
service  corporations  becomes  sufficiently  large  to  affect  ma- 
terially the  determination  of  corporate  solvency.  In  an  in- 
ventory of  these  materials  and  supplies  the  valuation  should 


122  CAPITAL   STOCKS 

ordinarily  be  based  upon  cost  prices  or  upon  prevailing  market 
prices  provided  these  do  not  exceed  cost.  This  is  the  custom- 
ary practice  of  all  conservative  accountants. 

A  method  sometimes  used  to  swell  revenues  artificially  has 
been  through  the  use  of  interdepartmental  accounts,  crediting 
one  department  for  services  alleged  to  have  been  rendered  to 
another  and  then  so  manipulating  the  entries  as  to  show  the 
constructive  departmental  revenues  as  being  revenues  of  the 
corporation.  For  instance,  the  operating  department  will 
render  services  to  the  construction  department,  making  a 
charge  for  the  service;  the  constructive  payment  is  charged 
to  the  capital  account  and  if  the  constructive  revenue  is 
credited  to  the  usual  revenue  accounts,  the  net  corporate  in- 
come will  be  greater  than  it  should  be  by  the  excess  of  the 
amount  charged  for  the  service  over  the  cost  of  rendering  the 
service.  Of  course,  if  the  service  is  bona-fide,  the  transaction 
is  a  proper  one,  but  the  charge  must  not  exceed  the  cost 
(estimated,  if  not  known)  to  the  operating  department,  and 
the  amount  must  not  be  credited  to  revenue  accounts  but  to 
operating  expense  accounts,  with  the  result  that  the  operating 
accounts  are  relieved  entirely  from  the  cost  of  service  which 
has  been  accounted  for  in  the  capital  accounts. 

To  shrink  expenses,  an  attempt  is  often  made  to  hold  in 
suspense  items  of  operating  expenses,  on  the  plea  that  they  are 
applicable  to  future  periods  and  should  not  be  made  to  burden 
the  revenues  of  the  present. 

So  far  as  the  accounting  of  public  service  corporations  has 
come  under  the  supervision  of  public  authority,  efforts  have 
been  made  and  are  being  made  through  the  enforcement  of 
correct  accounting  principles  to  prevent  such  abuses.  Much 
more  can  be  accomplished,  however,  through  the  insistence  of 
stockholders  that  their  directors  shall  deal  honestly  with  them 
so  that  payments  purporting  to  represent  dividends  shall  really 
represent  a  distribution  of  the  surplus  profits  and  not  of 
capital. 


DIVIDENDS 


123 


§  67.     Amount  of  Surplus  Which  May  Be  Divided 

The  question  of  what  constitutes  "profits"  within  the  mean- 
ing of  statutes  has  proved  very  perplexing.  The  foregoing 
paragraphs  have  described  difficulties  in  arriving  at  a  correct 
figure  of  corporate  surplus  even  where  the  accounts  are  regu- 
lated. At  best,  the  final  result  of  all  the  accounting  is  only  a 
"book  surplus,"  Is  it  this  figure  that  must  control  the  distri- 
bution of  dividends  if  the  statute  is  to  be  observed?  Or  may 
the  corporation  make  up  a  statement  of  "surplus  profits"  ap- 
portionable  as  dividends,  omitting  therefrom  or  substituting 
therein  different  amounts  for  some  items  which  went  to  make 
up  the  book  surplus? 

One  important  question  is  whether  the  statute  permits  the 
profits  of  any  one  period  to  be  apportioned  for  dividends  if 
there  also  exists  a  deficit  balance  from  the  operations  of  pre- 
ceding years,  or  if  it  requires  that  these  profits  be  first  applied 
to  making  good  the  impairment  of  capital  resulting  from  past 
operations.  Then,  again,  if  the  accumulated  deficit  must  be 
made  good  before  the  profits  earned  in  any  one  year  may  be 
distributed  as  dividends,  may  any  distinction  be  made  between 
the  impairment  of  capital  which  was  caused  by  losses  in- 
curred in  operation  or  by  adjustments  in  value  of  capital 
assets? 

Courts  have  often  been  called  upon  to  say  whether  or  not 
certain  dividend  payments  represented  the  apportionment  of 
surplus  profits  or  of  capital.  It  is  impossible,  however,  to 
marshal  the  decisions  into  the  statement  of  one  specific  rule. 
The  United  States  Supreme  Court  has  declared  that  "there  is 
no  difficulty  in  ascertaining  the  amount  of  such  profits  in  any 
year,"  referring  to  "that  portion  of  the  net  earnings  of  the 
company  which  legitimately  constitute  profits  and  could  be 
rightfully  apportioned  or  distributed  among  shareholders."  ^ 
The  court  in  this  case  approved  the  rule  laid  down  in  an  earlier 
decision  to  the  effect  that  "net  earnings  are  properly  the  gross 

3  Mobile  and  Ohio  R.  R.  v.  Tennessee,  1531  U.  S.  486  (497). 


124  CAPITAL   STOCKS 

receipts  less  the  expenses  of  operating  the  road  to  earn  such 
receipts.  Interest  on  debts  is  paid  out  of  what  thus  remains — 
that  is,  out  of  the  net  earnings.  Many  other  liabilities  are  paid 
out  of  the  net  earnings.  When  all  liabilities  are  paid,  either 
out  of  the  gross  receipts  or  out  of  the  net  earnings,  the  re- 
mainder is  the  profit  of  the  shareholders,  to  go  toward  divi- 
dends, which,  in  that  way,  are  paid  out  of  net  earnings."  * 

English  Court  Decisions.  Some  of  the  decisions  rendered 
by  the  courts  of  England  have  contained  very  interesting  dis- 
cussions of  these  questions;  two  opinions  written  by  Judge 
Lindley  of  the  Chancery  Division  are  especially  valuable.  In 
one  case  he  wrote: 

"The  word  'profits'  is  by  no  means  free  from  ambiguity. 
The  law  is  much  more  accurately  expressed  by  saying  that 
dividends  cannot  be  paid  out  of  capital,  than  by  saying  that 
they  can  only  be  paid  out  of  profits.  The  last  expression  leads 
to  the  inference  that  the  capital  must  always  be  kept  up  and  be 
represented  by  assets  which,  if  sold,  would  produce  it;  and 
this  is  more  than  is  required  by  law.  Perhaps  the  shortest 
way  of  expressing  the  distinction  which  I  am  endeavoring  to 
explain  is  to  say  that  fixed  capital  may  be  sunk  and  lost,  and 
yet  that  the  excess  of  current  receipts  over  current  payments 
may  be  divided,  but  that  floating  or  circulating  capital  must 
be  kept  up,  as  otherwise  it  will  enter  into  and  form  part  of 
such  excess,  in  which  case  to  divide  such  excess  without  de- 
ducting the  capital  which  forms  part  of  it  will  be  contrary  to 
law. 

"  ....  In  order  to  show  what  has  been  subscribed  by 
the  shareholders  and  what  has  become  of  the  money  so  sub- 
scribed, and  to  show  the  results  of  the  company's  trading  or 
business,  it  is  practically  necessary  to  keep  a  capital  account 
and  what  is  called  a  profit  and  loss  account,  and  as  a  matter  of 
business  these  accounts  ought  to  be  kept  as  business  men  usually 
keep  them.    Accordingly,  we  find  provisions  for  keeping  such 

*  St.  John  V.  Erie  Ry.  Co.,  lo  Blatchford  279;  aff'd,  2a  Wall.  136. 


DIVIDENDS 


125 


accounts  in  Table  A  in  the  Appendix  of  the  Companies  Act, 
1862,  and  in  the  articles  of  association  of  most,  if  not  all, 
companies.  But  there  is  no  law  which  compels  limited  com- 
panies in  all  cases  to  recoup  losses  shown  by  the  capital  ac- 
count out  of  the  receipts  shown  in  the  profit  and  loss  account, 
although  care  must  be  taken  not  to  treat  capital  as  if  it  were 
profit."  ' 

In  an  earlier  case  Judge  Lindley  had  presented  the  follow- 
ing illustration  and  argument: 

"Suppose  a  company  is  formed  to  start  a  daily  newspaper; 
supposing  it  sinks  £250,000  before  the  receipts  from  sales  and 
advertisements  equal  the  current  expenses,  and  supposing  it 
then  goes  on,  is  it  to  be  said  that  the  company  must  come  to  a 
stop,  or  that  it  cannot  divide  profits  until  it  has  replaced  its 
£250,000,  which  has  been  sunk  in  building  up  a  property  which 
if  put  up  for  sale  would  perhaps  not  yield  £10,000?  That  Is 
a  business  matter  left  to  business  men.  If  they  think  their 
prospects  of  success  are  considerable,  so  long  as  they  pay  their 
creditors,  there  is  no  reason  why  they  should  not  go  on  and 
divide  profits,  so  far  as  I  can  see,  although  every  shilling  of 
the  capital  may  be  lost.  It  may  be  a  perfectly  flourishing  con- 
cern, and  the  contrary  view,  I  think,  is  to  be  traced  to  this, 
that  there  is  a  sort  of  notion  that  the  company  is  debtor  to  capi- 
tal. In  an  accountant's  point  of  view,  it  is  quite  right,  in 
order  to  see  how  you  stand,  to  put  down  company  debtor  to 
capital.  But  the  company  does  not  owe  the  capital.  What  it 
means  is  simply  this:  that  if  you  want  to  find  out  how  you 
stand,  whether  you  have  lost  your  money  or  not,  you  must 
bring  your  capital  into  account  somehow  or  other  ....  The 
company  is  not  debtor  to  capital ;  the  capital  is  not  a  debt  of 
the  company. 

"Having  shown  from  the  Acts  (negatively,  of  course,  be- 
cause this  is  a  negative  proposition,  and  can  only  be  proved  by 
looking  through  the  Acts)  that  the  Acts  do  not  require  the 

"Verner  v.  Gen'l.  etc.  Trust,  L.  R.  Ch.  D.  (1894),  Vol.  2,  p.  239  (266). 


126  CAPITAL    STOCKS 

capital  to  be  made  up  if  lost,  I  cannot  find  anything  in  them 
which  precludes  payment  of  dividends  so  long  as  the  assets  are 
of  less  value  than  the  original  capital."  ^ 

"It  is  easy  to  lay  down  as  an  abstract  proposition  that  you 
must  not  pay  dividends  out  of  capital;  but  the  application  of 
that  very  plain  proposition  may  raise  questions  of  the  utmost 
difficulty  in  their  solution,"  wrote  the  Earl  of  Halsbury,  L.  C, 
setting  forth  his  decision  in  a  case  which  had  gone  to  the 
House  of  Lords  on  appeal.  "Even  the  distinction  between 
fixed  and  floating  capital,  which  may  be  appropriate  enough 
in  an  abstract  treatise  like  Adam  Smith's  'Wealth  of  Nations,' 
may  with  reference  to  a  concrete  case  be  quite  inappropriate." 
Continuing,  he  says: 

"As  an  illustration  of  what  difficulties  may  arise  the  ex- 
ample given  by  the  learned  counsel  of  one  ship  being  lost  out 
of  a  considerable  number,  and  the  question  whether  all  divi- 
dends must  be  stopped  until  the  value  of  that  lost  ship  is  made 
good  out  of  the  further  earnings  of  the  company  or  partner- 
ship, is  one  which  one  would  have  to  deal  with.  On  the  one 
hand,  people  put  their  money  into  a  trading  concern  to  give 
them  an  income  and  the  sudden  stoppage  of  all  dividends 
would  send  down  the  value  of  their  shares  to  zero  and  possibly 
involve  its  ruin ;  on  the  other  hand,  companies  cannot  at  their 
will  and  without  the  precautions  enforced  by  the  statute  re- 
duce their  capital.  But  what  are  profits  and  what  is  capital 
may  be  a  difficult  and  sometimes  an  almost  impossible  problem 
to  solve.  When  the  time  comes  that  these  questions  come  be- 
fore us  in  a  concrete  case  we  must  deal  with  them,  but  until 
they  do  I  for  one  decline  to  express  an  opinion  not  called  for 
by  the  particular  facts  before  us;  I  am  the  more  averse  to 
doing  so,  because  I  foresee  that  many  matters  will  have  to  be 
considered  by  men  of  business  which  are  not  altogether 
familiar  to  a  Court  of  Law."  ^ 


«Lee  V.   Neuchatel  Asphalte  Co.,  L.  R.,  41   Ch.   D.    (1889),  20  {22). 
'  Dovey,  etc.  v.  Cory,  1901  L.  R.  (A.  C.)  4-7  (486). 


DIVIDENDS 


127 


Summary.  The  American  and  English -courts  do  not  seem 
to  be  far  apart  in  the  interpretation  which  they  place  upon  the 
statutes  requiring  payment  of  dividends  out  of  surplus  profits 
only.  It  may  be  said  that  in  general  they  have  emphasized  the 
reality  of  actual  profits  on  hand  in  the  particular  case  before 
them  and  have  not  dealt  very  much  with  the  accounting 
aspects;  if  the  receipts  leave  a  balance  on  hand  after  taking 
care  of  the  expenses,  taxes,  etc.,  they  have  upheld  the  distri- 
bution of  dividends.  The  writer  does  not  know  of  any  case 
which  has  involved  the  question  of  the  effect  to  be  given  to 
accounting  rules  established  by  regulating  commissions,  and 
it  still  remains  to  be  seen  whether  the  courts  will  insist  upon  a 
book  surplus  as  the  basis  of  dividends  by  these  regulated 
companies.  The  commissions  themselves  have  not  made  any 
rulings  on  the  subject,  providing  for  the  deduction  of  divi- 
dends either  out  of  the  net  incomes  or  the  accumulated  surplus. 

From  a  business  standpoint,  the  entire  amount  of  surplus 
should  not,  as  a  general  proposition,  be  divided  among  the 
stockholders.  The  corporation  should  at  all  times  maintain  a 
reasonable  surplus  to  support  its  general  credit,  to  maintain 
continuity  of  dividends,  and  to  meet  unforeseen  contingencies. 

§  68.     Dividends  in  Relation  to  Wasting  Assets 

A  somewhat  different  rule  from  that  above  described  ob- 
tains in  the  case  of  dividend  payments  representing  in  part 
the  exhaustion  of  wasting  capital.  The  only  class  of  public 
service  corporations  subject  to  these  considerations  are  those 
engaged  in  the  production  and  distribution  of  natural  gas. 
Manifestly  the  proceeds  of  the  sale  of  natural  gas  should  in- 
clude not  only  the  operating  costs  and  profit  on  investment  but 
also  such  a  proportion  of  the  cost  of  acquiring  and  drilling  the 
wells,  i.e.,  of  the  fixed  capital,  as  will  represent  the  cost  of 
the  gas  in  situ;  hence  the  excess  of  revenues  over  operating 
expenses,  taxes,  and  deductions  does  not  represent  profit  alone 
but  includes  a  return  of  the  original  invested  capital.     The 


128  CAPITAL   STOCKS 

principle  is  the  same  as  that  applicable  to  any  other  opera- 
tion, i.e.,  the  cost  of  the  product  always  includes  something 
for  the  destruction  of  fixed  capital  as  well  as  the  cost  of  ma- 
terial consumed  and  labor  expended.  The  distinction,  such  as 
there  is,  is  one  of  degree.  In  this  case,  however,  because  of  the 
uncertainty  of  the  quantity  of  gas  in  the  wells,  the  actual  pro- 
portion of  the  original  investment  so  returned  cannot  be  de- 
termined, and,  should  the  whole  amount  of  the  excess  of 
revenue  over  deductions  be  distributed  as  dividends,  the 
amount  of  dividends  will  represent  in  part  the  distribution  of 
capital.  Yet  this  is  considered  proper  in  view  of  the  tempor- 
ary nature  of  the  venture  and  due  to  the  character  of  the 
natural  resources  invested  in.  Such  a  venture  is  a  wholly 
speculative  one  and  investors  in  the  stock  of  the  corporation 
are  well  aware  of  the  nature  of  the  undertaking,  if  they  have 
acted  at  all  intelligently.  Since  the  duration  of  the  supply  is 
unknown,  the  logical  policy  of  the  corporation  would  seem  to 
be  to  distribute  among  its  stockholders  the  proceeds  of  the 
venture  as  fast  as  these  come  in;  the  aim  being  to  return  to 
the  investors  as  quickly  as  possible  the  amount  of  their  in- 
vestment, limiting  speculation  as  to  profits  to  the  possible 
supply  which  may  remain  after  the  original  investment  of  the 
stockholders  has  been  safeguarded.  This  seems  to  be  wholly 
logical  and  its  justification  has  been  definitely  recognized  by 
the  courts.  Creditors'  interest  should,  of  course,  be  protected. 
There  are  those  who  contend  that  these  enterprises  should 
be  regarded  as  permanent,  the  capital  of  which  should  be 
maintained.  This  means  that  depreciation  appropriations 
should  be  large  enough  to  raise  a  reserve  to  make  good  the 
entire  cost  of  each  well  as  it  becomes  exhausted. 

§  69.     Stockholders'   Title   to,   and    Remedy   for.    Undivided 
Profits 

Until  declaring  a  dividend,  the  corporation  holds  all  the 
profits  of  its  operations  precisely  as  it  holds  any  other  corpor- 


DIVIDENDS  129 

ate  property.  The  stockholders  do  not  acquire  any  vestige 
of  legal  title  therein  different  from  their  general  and  un- 
divided interest  in  the  corporate  assets  as  a  whole.  It  is  en- 
tirely within  the  powers  and  privileges  of  the  directors  to  apply 
to  the  increase  of  the  permanent  corporate  assets,  in  exten- 
sions of  its  plant  or  operations,  etc.,  all  or  any  part  of  the 
profits  accruing  from  the  use  of  the  capital  theretofore  in- 
vested, i.e.,  to  build  up  the  capital  out  of  earnings,  instead  of 
dividing  the  earnings  among  stockholders ;  provided,  of  course, 
that  such  withholding  of  corporate  dividends  is  made  in  entire 
good  faith. 

Under  many  circumstances  the  practice  of  building  up 
capital  out  of  earnings  (i.e.,  out  of  income)  is  a  commendable 
one.  It  is  a  matter,  however,  of  which  both  the  public  and 
the  stockholders  are  entitled  to  accurate  knowledge.  The  pub- 
lic is  interested  in  knowing  how  much  of  the  fixed  capital  re- 
ported by  the  corporation  has  been  contributed  by  the  security 
holders,  and  how  much  has  been  added  from  the  earnings  of 
the  business.  The  stockholder  is  interested  because  the  appli- 
cation of  earnings  to  additions  and  betterments  represents  an 
increase  of  assets  in  proportion  to  which  he  may  add  to  the 
valuation  of  his  holdings.  To  show  this  information  the 
accounting  classifications  and  report  forms  of  the  Interstate 
Commerce  Commission  introduce,  among  the  accounts  of 
carriers  showing  the  disposition  of  Net  Income  or  Surplus, 
accounts  entitled  "Income  (or  Surplus)  Appropriated  for  In- 
vestment in  Physical  Property."  Appropriations  for  addi- 
tions to  and  betterments  of  road  and  equipment,  or  for  the 
construction  of  new  lines  or  extensions,  are  debited  to  these 
accounts,  while  concurrent  credits  are  made  to  a  balance  sheet 
account,  "Additions  to  Property  Through  Income  and  Sur- 
plus," if  already  expended,  or  to  "Appropriated  Surplus  Not 
Specifically  Invested"  if  unexpended.  A  glance  at  the  income 
statement  will  thus  show  what  portion  of  the  earnings  for  that 
period  has  been  appropriated  to  the  building  up  of  capital, 


I30 


CAPITAL   STOCKS 


and  the  balance  sheet  will  as  readily  show  the  total  earnings 
appropriated  to  date,  together  with  the  separation  between  ex- 
pended sums  and  unexpended  balances  remaining  available. 

It  has  been  shown  before  that  the  full  legal  title  to  all  assets 
is  in  the  corporation,  and  the  beneficial  interest  of  stockholders 
is  purely  equitable,  not  legal;  hence,  a  stockholder  may  not 
maintain  an  action  at  law  for  the  recovery  of  a  portion  of  the 
undivided  surplus,  just  as  he  may  not  maintain  an  action  for 
the  apportionment  to  himself  of  a  proportion  of  the  capital 
assets  of  the  corporation.  Any  right  that  the  stockholder  may 
have,  therefore,  of  compelling  the  declaration  and  distribution 
of  dividends,  is  also  purely  ecjuitable,  not  legal.  As  soon  as 
profits  are  divided  and  declared  as  dividends,  they  at  once  be- 
come the  property  of  the  several  stockholders  in  proportion  to 
their  respective  holdings;  thereupon  any  stockholder  may 
maintain  an  action  at  law  for  the  recovery  of  the  property  to 
which  he  has  become  legally  entitled,  should  the  corporation 
refuse  to  pay  it  to  him  at  or  after  the  time  of  payment  speci- 
fied in  the  resolution  of  the  directors  declaring  the  dividend. 

While  it  is  within  the  rights  of  the  stockholders  to  main- 
tain an  action  in  equity  to  compel  the  declaration  of  dividends, 
courts  of  equity  have  proved  themselves  loath  to  review  the 
action  of  directors  in  declaring  or  refusing  to  declare  divi- 
dends, except  where  the  refusal  is  tainted  with  fraud  or  arises 
out  of  the  attempt  to  manipulate  the  corporate  afifairs  so  as 
to  favor  one  class  or  portion  of  stockholders  at  the  expense 
of  another,  or  where  a  distribution  has  been  made  for  some 
class  of  stock  contrary  to  the  statutes  or  charter  provisions. 
The  majority  stockholders  control  the  machinery  of  the  cor- 
poration, and  in  appointing  representatives  to  direct  the  cor- 
porate affairs  they  impose  upon  themselves  and  all  other  stock- 
holders the  obligation  to  be  bound  by  the  acts  of  their  repre- 
sentatives committed  in  the  recognized  course  of  their  duties. 
If  they  become  dissatisfied  with  those  representatives,  they 
have  the  necessary  power  to  oust  them.     Naturally,  there 


DIVIDENDS 


131 


would  need  to  exist  very  peculiar  circumstances  to  justify  the 
majority  stockholders  in  invoking  the  aid  of  the  court  against 
the  acts  of  the  directors ;  a  minority  stockholder,  on  the  other 
hand,  has  voluntarily  entered  into  a  relationship  where  his 
interest  is  subject  to  the  control  of  others,  hence  it  is  entirely 
proper  that  courts  should  hesitate  to  relieve  him  from  the 
burden  of  his  contract  unless  fraud  or  unconscionable  dealing 
be  alleged  of  the  other  parties  to  the  contract. 

§  70.     Mediums  of  Distribution 

Undivided  profits  mingle  with  and  increase  the  value  of 
the  other  assets ;  they,  therefore,  correspondingly  increase  the 
value  of  the  shares  of  stock.  Upon  distribution  as  dividends, 
the  corporate  assets  decrease  and  the  value  of  each  share  goes 
back  to  what  it  was  before  the  accumulation  of  the  profits, 
assuming  the  absence  of  other  forces  affecting  the  value  of 
stock.  (The  intrinsic  value,  not  the  market  or  par  value,  is 
here  referred  to.)  In  effect,  then,  to  declare  and  pay  divi- 
dends is  to  make  readily  available  to  the  stockholder  a  portion 
of  the  property  in  which  he  theretofore  has  had  only  a  bene- 
ficial and  contingent  interest — it  changes  his  beneficial  interest 
into  real  ownership.  The  manner  in  which  this  is  done  is  im- 
material; the  division  can  be  made  in  actual  apportionment 
of  property,  if  that  is  practicable,  or  in  any  other  form  suffi- 
cient to  accomplish  the  purpose.  A  number  of  methods  have 
been  adopted  and  used ;  dividends  have  been  declared  and  paid 
in  cash,  in  scrip,  in  certificates  of  indebtedness  (scrip  or 
bonds),  or  in  property.  To  carry  out  the  general  principle  of 
dividend  payments,  the  method  used  must  be  such  as  to  make 
readily  available  to  the  stockholder  the  proportion  of  profits 
allotted  to  him,  otherwise  little  will  be  accomplished  since  he 
was  already  possessed  of  the  beneficial  ownership  in  the  profits 
remaining  undivided  in  the  hands  of  the  company.  The  opera- 
tion of  this  rule  is,  of  course,  subject  to  the  dictates  of  ex- 
pediency. 


132 


CAPITAL  STOCKS 


It  is  sometimes  asserted  that  affirmative  authority,  by 
statute  or  charter,  is  required  for  the  payment  of  dividends  in 
any  form  other  than  cash.  The  generally  accepted  rule  has 
been,  however,  that  so  long  as  the  profits  have  been  actually 
earned,  the  question  of  whether  dividends  shall  be  paid  in 
cash  or  otherwise,  in  the  absence  of  statutory  enactments  (of 
which  there  are  few)  or  specific  provision  of  charter  or  by- 
laws, rests  entirely  in  the  discretion  of  the  directors.  A  holder 
of  common  stock  is  not  privileged  to  demand  the  apportion- 
ment of  dividends  to  himself  in  any  particular  form.  It  is 
probably  true,  however,  that  in  the  absence  of  specific  agree- 
ment the  holders  of  preferred  stock  entitled  to  dividends  at  a 
stipulated  rate  are  privileged  to  demand  payment  in  cash. 

The  payment  of  dividends  in  rights  or  property  other  than 
money,  is  resorted  to  where  the  profits  earned  are  sufficient 
for  the  purpose  of  dividends  but  have  been  converted  into 
some  kind  of  property  used  in  the  business  so  that  they  are 
not  available  for  distribution  in  cash.  If  profits  so  tied  up  had 
to  be  distributed  in  money,  the  corporation  would  probably 
need  to  borrow  the  sums  necessary  for  that  purpose.  Borrow- 
ing money  to  pay  dividends  is  often  considered  a  suspicious 
practice,  but  it  is  not  necessarily  so;  if  profits  have  been  actu- 
ally earned  and  the  loan  can  be  soon  repaid  so  as  not  to  make 
the  interest  burden  unduly  heavy,  the  practice  is  a  proper  one. 
But  where  the  profits  are  tied  up  and  the  circumstances  are 
such  as  not  to  warrant  the  use  of  borrowed  money,  the  dis- 
tribution of  those  profits  may  be  accomplished  by  the  declara- 
tion of  dividends  payable  otherwise  than  in  money. 

"It  is  apparent  that  where  the  corporation,  instead  of  dis- 
posing of  the  property  in  which  the  profits  have  been  invested 
and  then  paying  the  dividends  from  the  proceeds,  prefers  to 
retain  the  property  and  postpone  payment  to  the  stockholders, 
it  is  reserving  the  property  from  which  it  is  fair  to  assume  it 
earns  a  return  sufficient  to  discharge  in  whole  or  in  part  the 
interest  upon  its  dividend  obligation.     Moreover,  it  had  the 


DIVIDENDS  133 

right,  if  it  so  elected,  to  borrow  the  money  with  which  to  pay 
dividends  where  it  had  invested  the  profits  in  improvements 
at  least  equalling  in  value  the  dividends  declared,  so  that  in- 
terest in  that  event  would  equally  be  a  charge  before  further 
dividends  could  be  declared  as  of  earnings."  ^ 

§  71.    Cash  Dividends 

Cash  dividends  are  the  rule;  it  is  the  most  equitable  and 
convenient  medium,  making  most  readily  available  to  the 
stockholder  the  portion  of  profits  to  which  he  has  become  en- 
titled. The  certificate  of  incorporation  may  specifically  pro- 
vide that  dividends  be  paid  only  in  cash,  and  the  requirement 
will,  of  course,  be  binding  upon  the  corporation  so  that  a  stock- 
holder will  be  under  no  obligation  to  accept  payment  in  any 
other  form.  Even  in  the  absence  of  any  provision,  dividends 
on  preferred  stock  are  almost  always  paid  in  cash. 

Instead  of  paying  dividend  warrants  at  its  own  office,  a 
corporation  may  deposit  a  sufficient  sum  with  its  fiscal  agent, 
usually  a  banking  corporation.  It  will  then  notify  the  stock- 
holders that  such  a  deposit  has  been  made,  usually  sending  to 
each  stockholder  a  certificate  or  check  which  can  be  redeemed 
at  the  office  of  the  depositary.  Having  done  so,  the  corpora- 
tion declaring  the  dividend  practically  transfers  the  primary 
liability  to  the  fiscal  agent,  itself  remaining  only  secondarily 
liable ;  to  hold  the  corporation  to  its  secondary  liability,  there- 
fore, the  stockholder  should  present  the  check  to,  or  make 
proper  demand  upon,  the  fiscal  agent  within  a  reasonable  time. 

§  72.     Scrip  Dividends 

Scrip  in  financial  transactions  denotes  a  temporary  paper 
or  certificate  redeemable  later  in  money  or  exchangeable  for 
some  permanent  certificate  or  whatever  else  the  scrip  may 
entitle  the  holder  to  receive;  accordingly,  a  scrip  dividend  is 
a  dividend  in  the  form  of  certificates  exchangeable  at  a  later 

«  Bankers  Trust  Co.  v.  Dietz  Co.,  157  A.  D.   (N.  Y.)  594,  (598). 


134 


CAPITAL    STOCKS 


determined  or  determinable  time,  or  at  the  option  of  the  com- 
pany, for  money,  shares  of  stock,  certificates  of  indebtedness, 
or  other  property. 

A  scrip  dividend  divides  the  profits  but  defers  the  actual 
distribution  of  assets.  The  declaration  of  scrip  dividends  is 
practically  notice  that  a  certain  amount  of  profits  has  been 
transferred  to  the  principal  of  the  capital  fund  or  is  repre- 
sented by  assets  which  cannot  be  immediately  converted  into 
cash.  If  the  scrip  is  redeemable  in  cash  its  effect  is  to  declare 
an  actual  dividend  but  with  a  postponed  date  of  payment. 
This  date  may  be  certain,  so  that  the  scrip  becomes  a  fixed 
obligation,  or  it  may  be  contingent  and  payable,  for  instance, 
as  soon  as  the  company  accumulates  sufficient  surplus  funds 
for  the  purpose,  or  when  specific  property  upon  which  the  scrip 
is  based  shall  be  sold.  If  the  scrip  is  a  fixed  obligation  it  will 
be  substantially  the  same  as  a  bond  dividend,  except  that  it 
will  not  earn  interest.  Sometimes  the  scrip  is  given  the  right 
to  participate  in  future  dividend  distributions;  it  then  par- 
takes much  of  the  nature  of  stock  except  that  it  carries  no  vot- 
ing power. 

Scrip  is  designated  as  "convertible"  if  it  is  made  exchange- 
able for  stock  or  bonds  of  the  company.  If  It  is  so  convertible 
it  can  be  considered  as  a  mere  incident  of  a  bond  or  stock 
dividend  and  subject  to  the  same  considerations  which  govern 
those  methods  of  dividend  distribution. 

If  the  profits  have  been  earned  and  have  been  used  in  ex- 
tending the  operations  or  have  in  some  way  become  tied  up  so 
that  they  cannot  actually  be  taken  out,  it  may  be  assumed 
that  the  investment  of  the  stockholder  is  so  much  bettered,  but 
the  situation  is  just  the  same  whether  a  certificate  is  given 
him  to  evidence  his  added  interest  or  not,  save,  of  course,  as  it 
makes  it  possible  for  him  to  realize  something  upon  the  sale  of 
the  scrip.  The  device,  nevertheless,  permits  the  corporation  to 
claim  that  it  has  maintained  dividends  and  at  least  lessens 
the  disappointment  of  stockholders. 


DIVIDENDS 


135 


It  may  be  used,  on  the  other  hand,  to  evade  a  statutory  pro- 
hibition, for  instance,  that  against  the  payment  of  dividends 
above  a  certain  rate ;  or  it  may  be  intended  to  avert  pubHc  criti- 
cism of  an  exceptionally  liberal  dividend.  For  these  purposes, 
however,  the  more  direct  device  of  a  stock  dividend  is  most 
usually  resorted  to. 

§  73.     Bond  Dividends 

A  bond  dividend  represents  the  apportionment  of  profits 
among  the  stockholders,  but  instead  of  paying  the  dividend 
in  cash,  the  issuing  corporation  creates  a  claim  against  itself 
for  the  amount  of  the  dividend  and  in  favor  of  the  stockholder, 
to  whom  it  issues  a  certificate  setting  forth  the  claim.  Upon 
maturity,  the  debt  is  payable  in  cash  while  in  the  meantime 
it  is  entitled  to  interest  which  becomes  a  fixed  charge  against 
the  company  to  be  paid  whether  further  profits  are  earned 
or  not.  A  bond  dividend  is  thus  essentially  a  forced  loan; 
the  stockholders  would  undoubtedly  prefer  cash  but  are  com- 
pelled to  take  evidences  of  indebtedness  instead;  they  receive 
the  certificates  acknowledging  a  loan  to  the  company,  but 
they  had  nothing  to  do  with  the  making  of  the  loan. 

A  bond  dividend  represented  by  interest-bearing  certifi- 
cates, unlike  a  scrip  or  stock  dividend,  does  vest  in  the  stock- 
holder a  claim  or  interest  which  he  did  not  theretofore  possess, 
viz.,  the  interest  of  a  creditor  and  the  claim  for  interest.  This 
latter  claim,  however,  may  represent  an  advantage  gained  at 
the  expense  of  another  class  or  other  classes  of  stock;  the 
bond  dividend  is  declared  upon  one  class  with  the  effect  of  in- 
creasing the  company's  fixed  charges,  the  profits  in  the  dis- 
tribution of  which  the  other  classes  of  stock  may  participate 
will  be  reduced,  while  the  holders  of  the  favored  shares  have 
their  bond  holdings  to  look  to  for  income. 

Statutory  Enactments.  Bond  dividends  are  sometimes, 
like  stock  dividends,  prohibited  by  statutory  enactments. 
Such  a  prohibition  has  been  read  into  the  provisions  of  the 


136  CAPITAL   STOCKS 

Public  Service  Commissions  Law  of  New  York  defining  the 
conditions  under  which  the  Commission  might  authorize  the 
issue  of  securities  by  a  corporation,  to  wit,  "when  necessary 
for  (i)  the  acquisition  of  property,  (2)  the  construction, 
completion,  extension  or  improvement  of  its  facilities,  or  (3) 
for  the  improvement  or  maintenance  of  its  service,  or  (4)  for 
the  discharge  or  lawful  refunding  of  its  obligations."  ^  The 
Erie  Railroad  Company  in  1907  declared  a  dividend  of  2  per 
cent  upon  the  first  preferred  stock  and  4  per  cent  on  the  second 
preferred  stock,  these  dividends  aggregating  $1,596,848.  Stat- 
ing that  "in  the  judgment  and  determination  of  this  company 
it  is  inexpedient  and  is  incompatible  with  the  best  interests  of 
the  company  and  of  its  stockholders  that  such  dividends, 
though  earned,  on  the  first  preferred  stock  and  second  pre- 
ferred stock,  should  be  paid  presently  in  cash  in  view  of  the 
pressing  and  dominant  demands  for  cash  for  the  extension  and 
improvement  of  the  railroad  heretofore  and  now  in  progress," 
the  directors  ordered  that  dividend  warrants,  running  for  a 
term  of  ten  years,  and  drawing  interest  at  the  rate  of  4  per 
cent  per  annum,  be  issued  in  lieu  of  a  cash  dividend.  The 
Public  Service  Commission,  acquiring  jurisdiction  under  the 
statute  quoted,  refused  to  authorize  the  issue  of  these  war- 
rants, holding  that:  *Tf  this  section  is  to  be  construed  as  not 
permitting  the  corporations  named  therein  to  issue  any  evi- 
dences of  indebtedness  whatever  except  for  the  purposes 
named  therein,  and  permitting  long  time  indebtedness  to  be 
incurred  only  for  such  purposes,  then  the  declaration  of  a 
dividend  payable  in  the  future  is  not  now  warranted  by  law." 
The  argument  leading  to  this  conclusion  is  worth  while  quoting 
at  length: 

"The  warrant  in  this  case  is  not  to  be  issued  for  the  dis- 
charge of  an  obligation  but  as  evidence  of  the  existence  of  an 
obligation  which  directors  create  at  the  time  of  issuing  of 

*  It  should  be  noted  that  this  case  was  decided  prior  to  the  amendment  of  1910 
which  permitted  capitalization  for  the  purpose  of  reimbursing  income.  Some  of  the 
statements  will  neeo  to  be  interpreted  with  this  fact  in  mind. 


DIVIDENDS 


137 


the  warrant  without  securing  anything  therefor.  This  is  op- 
posed to  the  whole  theory  of  the  statute,  which,  from  every 
possible  point  of  view,  requires  the  securing  by  the  company 
of  some  value  or  property  which  it  did  not  before  possess  by 

reason  of  the  issuing  of  its  evidence  of  indebtedness 

"A  dividend  is  the  dividing  of  property  among  the  stock- 
holders ;  it  is  the  direct  opposite  of  the  securing  of  capital.  It 
is  parting  with  it.  A  promise  to  divide  in  the  future  is  simply 
a  promise  to  part  with  that  property  in  the  future.  The  cor- 
poration secures  nothing  by  the  dividend.  After  declaring  the 
dividend  it  possesses  no  capital  which  it  did  not  possess  before. 
The  money  which  it  promises  to  divide  at  a  future  time  still 
remains  the  money  of  the  corporation.  It  can  be  applied  to 
any  lawful  purpose  of  the  corporation  at  the  discretion  of  the 
directors,  and  after  the  declaration  of  a  dividend  payable  in 
the  future  it  has  no  more  power  or  authority  over  the  fund 
which  it  promises  to  divide  than  it  had  before  the  declaration 
of  a  dividend.  Every  dollar  of  the  money  or  property  which 
warrants  the  declaration  of  such  a  dividend  is  already  the 
property  of  the  company  and  nothing  new  is  secured  there- 
by. ..  .  It  is  clear  that  warrants  evidencing  a  scrip  dividend 
cannot  be  issued  under  that  section  for  the  plain  reason  that 
no  capital  is  secured  thereby.  Nor  can  the  issuing  of  such  war- 
rants be  necessary  for  one  of  the  purposes  enumerated  in  the 
statute,  for  the  equally  plain  reason  that  after  their  issue  the 
directors  have  no  power  to  apply  the  surplus  to  one  of  the  re- 
quired purposes  other  than  they  possessed  before  the  declara- 
tion of  the  dividend.  Nothing  can  be  justly  said  to  be  neces- 
sary in  this  connection  unless  its  existence  is  required  to  enable 
something  to  be  done  which  would  otherwise  be  impossible. 
By  the  declaration  of  a  dividend  payable  in  the  future  no  part 
of  the  surplus  has  been  transferred  to  the  stockholders.  The 
directors  themselves  have  no  more  and  no  less  power  over 
it  than  was  possessed  by  them  before  the  declaration  of  the 
dividend.    The  making  of  such  a  dividend  is  not  a  loan  by  the 


138  CAPITAL   STOCKS 

Stockholders  to  the  company.  Such  a  thing  as  a  loan  cannot 
be  without  receiving  something  from  the  stockholders  and 
with  their  consent,  and  that  is  not  the  case.  A  scrip  dividend 
is  a  mere  promise  to  pay  something  to  the  stockholders  in  the 
future.  Absolutely  nothing  is  received  from  them  and  noth- 
ing is  taken  from  the  company  at  the  present  time.  In  its 
essential  nature  it  is  nothing  but  a  promise  to  pay  to  the  stock- 
holders at  a  future  time  a  sum  of  money,  and  for  this  promise 
it  receives  no  consideration  whatever.  How  can  such  a 
promise  be  said  to  be  necessary  for  any  purpose?"  ^^ 

Other  statutory  provisions  regulating  the  issue  of  scrip  and 
bond  dividends  are  discussed  below  in  connection  with  stock 
dividends. 

§  74.     Stock  Dividends 

A  stock  dividend  also  represents  the  apportionment  of 
profits  among  the  stockholders,  but,  unlike  the  scrip  or  bond 
dividends,  makes  no  provision  for  an  actual  distribution  in 
cash  at  any  time;  the  evidence  of  the  apportionment  of  profits 
as  dividends  received  by  the  stockholder  consists  of  additional 
shares  of  stock  issued  for  the  amount  of  the  dividends. 

Since  the  beneficial  ownership  of  a  stockholder  takes  in  all 
the  corporate  assets,  including  all  profits  earned  and  remaining 
undistributed,  it  follows  that  the  value  of  the  entire  interest  of 
the  stockholder  is  the  same  before  as  after  the  declaration  of 
a  stock  dividend;  the  declaration  merely  changes  the  form  of 
the  evidence  of  the  stockholder's  interest  by  increasing  the 
number  of  shares  while  lessening  the  actual  value  per  share, 
the  aggregate  value  of  the  entire  interest  remaining  un- 
changed. It  adds  nothing  to  the  capital  of  the  corporation, 
nor  to  the  ownership  of  the  stockholder.  The  issue  of  new 
shares,  however,  does  make  it  possible  for  the  stockholder  to 
realize  cash  to  the  amount  of  the  dividends  by  selling  the  ad- 
ditional shares,  leaving  his  interest  as  before. 

'0  Matter  of  Erie  R.  R.  Co.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  115. 


DIVIDENDS 


139 


If  he  retains  the  shares  issued  to  him  as  a  stock  dividend, 
the  total  amount  of  stock  sharing  in  dividend  distributions 
is  correspondingly  increased,  and  if  dividends  are  maintained 
thereafter  at  the  same  rate  as  before,  his  future  dividend  in- 
come will  be  so  much  larger.  Frequently  dividends  have  been 
paid  in  stock  so  as  to  increase  the  amount  of  capital  stock  upon 
which  future  dividends  will  be  declared,  and  so  that  the  actual 
rate  of  these  other  dividends  might  be  expressed  as  6,  8,  or 
10  per  cent  instead  of  12,  16,  or  20  per  cent  upon  the  smaller 
capitalization.  This  is  done  where  it  is  feared  that  the  higher 
rates  will  invite  agitation  for  the  reduction  of  charges,  ex- 
tension of  service  into  unprofitable  territory,  etc. 

Much  of  what  has  been  said  of  scrip  and  bond  dividends 
applies  also  to  stock  dividends.  Stock  dividends  have  been 
much  more  common  than  either  bond  or  scrip  dividends,  and 
have  been  subjected  to  much  more  litigation  and  legislation. 
In  some  states,  as  in  Massachusetts,  stock  dividends  are 
specifically  prohibited.  The  statute  of  New  York  State,  already 
quoted,  has  been  interpreted  by  the  Public  Service  Commission 
of  the  Second  District  to  prohibit  the  issue  of  stock  dividends 
as  well:  "A  stock  dividend  by  corporations  subject  to  our 
jurisdiction  is  not  now  permitted  by  law."  ^^ 

The  laws  of  Wisconsin  contain  specific  prohibition:  "No 
public  service  corporation  shall  declare  any  stock  or  bond  divi- 
dend, or  divide  the  proceeds  of  the  sale  of  any  stock  or  bonds 
among  its  stockholders."  That  statute  is  qualified,  however, 
in  that  it  permits  the  issue  of  securities  "for  so  increasing  the 
total  amount  of  its  stocks,  certificates  of  stock,  bonds,  notes, 
and  other  evidences  of  indebtedness,  where  such  total  is  less 
than  the  value  of  its  property,  as  found  by  the  Commission,  as 
to  equal  or  more  nearly  equal  such  value."  Securities  thus 
issued  would,  of  course,  be  distributed  among  the  stockholders 
as  special  dividends,  even  without  express  permission,  which 
is,  nevertheless,  granted:    "Such  new  stocks,  certificates  of 

"Matter  of  Babylon  Electric  Light  Co.,  i  P.   S.  C.  Rep.    (2nd  D.,  N.  Y.)    133. 


140 


CAPITAL   STOCKS 


Stock,  bonds,  notes,  or  other  evidence  of  indebtedness,  or  any 
part  thereof,  or  the  proceeds  or  any  part  of  the  proceeds  de- 
rived therefrom,  may  be  distributed  equally,  share  for  share, 
among  the  holders  of  stock  or  certificates  of  stock  of  such 
corporation  already  issued." 

A  situation  similar  to  the  above  M^ill  arise  wherever  the 
statutes,  although  silent  as  to  dividends  payable  other  than  in 
cash,  authorize  the  issue  of  securities  to  place  the  capitalization 
on  a  par  with  the  physical  value  of  the  property;  provisions  to 
that  effect  were  included  in  a  federal  bill  proposed  some  years 
ago  to  vest  in  the  Interstate  Commerce  Commission  authority 
over  the  issue  of  securities  by  interstate  commerce  corpora- 
tions. 

On  the  other  hand,  the  public  utilities  laws  of  a  number 
of  states  expressly  permit  the  declaration  of  stock  dividends; 
among  these  are  Maine,  Missouri,  and  Ohio.  The  statute  of 
the  last  named  state  reads:  "No  public  utility  or  railroad  shall 
declare  any  stock,  bond,  or  scrip  dividend  or  divide  the  pro- 
ceeds of  the  value  of  any  stock,  bond  or  scrip  among  its  stock- 
holders, unless  authorized  by  the  Commission  so  to  do." 

Under  provisions  similar  to  this  there  have  been  a  number 
of  instances  in  which  the  distribution  of  stock  dividends  has 
been  expressly  authorized ;  for  instance,  the  Ohio  Commission 
authorized  one  of  the  corporations  subject  to  its  jurisdiction 
"to  issue  and  distribute,  pro  rata,  to  the  holders  of  its  present 
outstanding  capital  stock,  a  stock  dividend  of  the  aggregate 
principal  sum  of  Fifty  Thousand  Dollars  ....  it  appearing 
that  said  capital  stock  is  to  be  issued  and  distributed  among 
the  holders  of  the  present  outstanding  capital  stock  of  the  com- 
pany in  lieu  of  the  surplus  earnings  thereof,  which  might 
otherwise  have  been  distributed  as  dividends,  but  were  ex- 
pended in  the  construction  of  additions  and  extensions  to  its 
plant  and  property." 

Where  stock  dividends  are  prohibited,  an  indirect  method 
is  sometimes  used  to  accomplish  the  same  end.    The  corpora- 


DIVIDENDS 


141 


tion  declares  dividends  in  the  regular  way,  payable  in  cash; 
at  the  same  time  additional  stock  of  an  amount  equal  to  the 
dividends  declared  is  offered  to  the  stockholders,  who  may 
purchase  the  shares  by  applying  the  amount  of  the  dividend 
to  the  purchase  price. 

Case  of  the  Nczv  York  Central  Railroad  Company.  The 
chief  objection  urged  against  the  declaration  of  stock  divi- 
dends is  the  supposed  facility  with  which  it  can  be  made  a 
device  for  stock-watering.  The  illustration  which  has  be- 
come almost  classical  by  repeated  use  is  the  declaration  of  a 
special  dividend  of  80  per  cent  by  the  New  York  Central  Rail- 
road Company  in  1868.  Following  the  declaration  of  the  divi- 
dend, this  company  was  consolidated  into  the  New  York 
Central  and  Hudson  River  Railroad  Company,  the  special 
dividend  distribution  practically  becoming  an  incident  of  the 
consolidation  project  as  a  whole.  The  merits  or  demerits  of 
the  transaction,  therefore,  should  not  be  appraised  without 
due  consideration  of  all  the  incidents  and  in  the  light  of  the 
special  circumstances  or  official  acts  by  which  they  were  sup- 
ported or  ratified.  Reference  to  these  can  be  found  in  the 
Special  Acts  of  the  New  York  Legislature  authorizing  or 
ratifying  the  various  steps  taken-in  the  project,  in  the  proceed- 
ings of  the  Hepburn  Committee  of  Investigation,  appointed 
in  1879,  and  in  Bailey  v.  Railroad  Co.,  89  U.  S.  (22  Wall.) 
604. 

The  court  decision  above  cited  narrates  the  circumstances 
attending  the  declaration  of  the  special  dividend  by  the  New 
York  Central  Railroad  Company.  The  distribution  of  these 
dividends  was  not  in  the  form  of  certificates  of  stock  but  of 
"interest  certificates,"  carrying  no  voting  rights,  issued  pur- 
suant to  the  followingf  resolution: 


'& 


Whereas,  This  company  has  hitherto  expended  of  its  earn- 
ings for  the  purpose  of  constructing  and  equipping  its  road, 
and  in  the  purchase  of  real  estate  and  other  properties,  with 
a  view  to  the  increase  of  its  traffic,  moneys  equal  in  amount 


J42  CAPITAL   STOCKS 

to  80  per  cent  of  the  capital  stock  of  the  company,  and 
whereas,  the  several  stockholders  of  the  company  are  entitled 
to  evidence  of  such  expenditures,  and  to  reimbursement  of 
the  same  at  some  convenient  period;  now,  therefore, 

Resolved,  That  a  certificate,  signed  by  the  president  and 
treasurer  of  this  company,  be  issued  to  the  stockholders  sev- 
erally, declaring  that  such  stockholder  is  entitled  to  80  per 
cent  of  the  amount  of  the  capital  stock  held  by  him,  pay- 
able ratably  with  the  other  certificates  issued  under  this 
resolution,  at  the  option  of  the  company,  out  of  its  future 
earnings,  with  dividends  thereon,  at  the  same  rates  and  times 
as  dividends  shall  be  paid  on  shares  of  the  capital  stock  of 
the  company,  and  that  such  certificates  may  be,  at  the  option 
of  the  company,  converted  into  stock  of  the  company,  when- 
ever the  company  shall  be  authorized  to  increase  its  capital 
stock  to  an  amount  sufficient  for  such  conversion. 

The  certificates  were  in  this  form: 

The  New  York  Central  Railroad  Company 
Interest  Certificate 
No 

Under  a  resolution  of  the  board  of  directors  of  this  com- 
pany, passed  December  19th,  1868,  of  which  the  above  is  a 
copy,  the  New  York  Central  Railroad  Company  hereby  cer- 
tifies that  A.  B.,  being  the  holder  of shares  of  the 

capital  stock  of  said  company,  is  entitled  to   dollars 

payable  ratably  with  the  other  certificates  issued  under  said- 
resolution  at  the  pleasure  of  the  company  out  of  its  future 
earnings,  with  dividends  thereon,  at  the  same  rates  and  times 
as  dividends  shall  be  paid  upon  the  shares  of  the  capital 
stock  of  said  company. 

This  certificate  may  be  transferred  on  the  books  of  the 
company  on  the  surrender  of  this  certificate. 

In  witness  whereof,  the  said  company  has  caused  this 
certificate  to  be  signed  by  its  president  and  treasurer,  this 
19th  day  of  December,  1868. 

The  status  of  these  certificates  went  before  the  United 
States  Supreme  Court  for  adjudication  in  order  that  the  In- 
ternal Revenue  Act  of  June  30,  1864,  might  be  given  effect 
in  respect  of  the  tax  provided  to  be  paid  by  "any  railroad 


DIVIDENDS 


143 


company  that  may  have  declared  any  dividend  in  scrip  or 
money  due  or  payable  to  its  stockholders,  as  part  of  the  earn- 
ings, profits,  income,  or  gains  of  such  company  carried  to  the 
account  of  any  fund  or  used  for  construction,"  the  rate  of  the 
tax  being  "5  per  centum  on  the  amount  of  all  such  dividends 
or  profits."  The  New  York  Central  Railroad  Company  had 
paid  this  tax  under  protest  and  sought  to  recover  the  amount 
thereof  from  the  collector.  The  court  declared  these  certi- 
ficates to  represent  "dividends  in  scrip,"  reciting  the  facts  of 
issue  as  follows: 

"For  years  the  ....  company  had  earned  moneys  greatly 
in  excess  of  their  current  expenses  without  any  satisfactory 
scheme  being  suggested  to  render  such  accumulating  surplus 
available  to  their  stockholders,  as  they  were  not  authorized  to 
increase  their  capital  stock  and  were  forbidden  by  law  to  make 
dividends  for  the  benefit  of  the  stockholders  beyond  ten  per 
cent.  Difficulties  of  the  kind  existing,  the  excess  of  earnings 
beyond  current  expenses  had  been  expended  in  constructing 
and  equipping  their  railroad  and  in  the  purchase  of  real  estate 
and  other  properties  with  a  view  to  the  increase  of  their  traffic. 

"Accumulations  of  the  kind  had  been  appropriated  in  that 
way  until  the  sum  amounted  in  the  aggregate  to  a  sum  equal 
to  eighty  per  cent  of  the  capital  stock  of  the  company.  Dis- 
satisfaction arose  among  the  stockholders,  and  all  admitted 
that  they  were  entitled  to  evidence  that  the  excess  of  the 
earnings  of  the  company  beyond  the  current  expenses  had  been 
appropriated  in  that  way,  and  to  reimbursement  of  the  same  at 
some  convenient  future  period. 

"Motives,  such  as  those  recited,  induced  the  company  to 
grant  the  certificates  ....  as  evidence  to  the  stockholders 
that  an  equal  amount  of  the  earnings  of  the  company  beyond 
current  expenses  had  been  expended  for  the  objects  stated  in 
the  preamble  of  the  certificates 

"These  certificates  are  not  dividends  in  money,  nor  are 
they  stock  or  certificates  of  stock  in  the  strict  sense,  but  they 


144  CAPITAL    STOCKS 

are  exactly  what  they  are  described  to  be  in  the  Revenue  Act, 
to  wit,  dividends  in  scrip." 

The  resoUition  declaring  the  special  dividend  of  the  New 
York  Central  Railroad  Company  was  adopted  December  19, 
1868,  and  on  May  20,  1869,  the  New  York  State  Legislature 
passed  a  law  authorizing  the  increase  of  capital  stock  "to  the 
amount  of  eighty  per  cent  of  its  present  capital,"  further  pro- 
viding that  "the  increase  of  capital  stock  authorized  .... 
shall  be  used  only  in  exchanging  the  same  for  the  interest 
certificates  of  said  company  authorized  at  their  meeting  held 
December  19,  1868."  Also  on  May  20,  1869,  the  Legislature 
passed  an  act  which  authorized  the  consolidation  of  the  New 
York  Central  Railroad  and  the  Hudson  River  Railroad  Com- 
panies. 

The  agreement  of  consolidation,  filed  with  the  Secretary  of 
State  November  i,  1869,  authorized  the  issue  of  $45,000,000 
capital  stock  to  be  exchanged  at  par  for  $28,795,000  stock  of 
the  New  York  Central  (interest  certificates  not  entering  into 
this  arrangement)  and  $16,208,000  stock  of  the  Hudson  River 
Railroad  Company.  In  addition,  the  agreement  authorized 
the  issue  of  "consolidation  certificates"  to  be  used  "for  the 
purpose  of  equalizing  the  values  of  the  property  of  said  Con- 
solidating Companies,  and  making  compensation  to  the  stock- 
holders of  said  Companies,  respectively,  for  all  differences  in 
such  values."  The  certificates  were  to  "be  payable  ratably,  at 
the  pleasure  of  the  Company,  out  of  its  future  earnings,"  and 
it  was  further  provided  that  "until  the  same  be  wholly 
paid  off  and  redeemed,  dividends  upon  the  amount  thereof 
shall  be  paid  at  the  same  rates  and  times,  as  dividends  shall  be 
paid  upon  the  shares  of  the  capital  stock."  The  issue  of  these 
certificates  was  in  the  proportion  of  %2y  for  each  $100  of  New 
York  Central  stock,  and  $85  for  each  $100  of  Hudson  River 
stock. 

Finally,  the  agreement  also  provided  that  the  capital  stock 
of  the  company  "may  at  any  time,  at  the  option  of  the  Board 


DIVIDENDS 


145 


of  Directors  of  the  consolidated  Company,  be  increased  to  an 
amount  sufficient  to  capitalize  at  par  the  interest  certificates 
heretofore  issued  by  the  New  York  Central  Railroad  Com- 
pany ....  and  the  consolidation  certificates  authorized  to 
be  issued  in  pursuance  of  this  agreement." 

§  75.     Property  Dividends 

A  property  dividend  consists  of  the  delivery  of  property 
other  than  money,  or  the  evidences  thereof.  It  represents  the 
distribution  not  of  an  amount  of  money  or  shares  or  bonds, 
but  of  actual  physical  property,  or  the  stocks  and  bonds  of 
another  corporation.  Because  of  the  practical  difficulties  in 
the  way  of  making  equitable  divisions  of  physical  property, 
dividends  of  this  kind  are  unusual.  •  The  form  in  which  they 
most  frequently  occur  is  the  distribution  of  securities  held  by 
the  corporation  either  as  investments  or  representing  the  con- 
sideration for  which  it  has  sold  all  or  some  part  of  its  property. 
The  securities  distributed  may  represent  either  investments 
made  by  the  company  out  of  profits  or  the  use  of  its  capital 
funds.  In  the  latter  case,  of  course,  the  distribution  would 
not  be  of  "dividends"  in  the  sense  of  dividing  profits,  but 
rather  a  device  to  return  to  the  stockholder  a  part  of  his 
original  investment.  In  this  last  phase  the  dividend  may  be 
an  incident  of  liquidation  and  the  entire  capital  of  the  cor- 
poration may  be  thus  disposed  of  in  such  a  case  as  the  sale 
of  the  entire  property  of  the  liquidating  corporation  to  an- 
other, the  purchase  price  being  received  in  securities  of  the 
purchasing  corporation. 

A  good  illustration  of  a  property  dividend  is  afforded  by 
the  declaration  of  an  extra  dividend  by  the  Union  Pacific 
Railroad  Company  January  8,  19 14,  which  was  payable  to 
the  holder  of  each  share  of  common  stock  as  follows:  12  per 
cent  in  Baltimore  &  Ohio  Railroad  Company  preferred  stock, 
223^  per  cent  in  Baltimore  &  Ohio  common  stock,  and  $3  in 
cash.     It  has  lately  been  proposed  that  dividends  be  paid  in 


146  CAPITAL   STOCKS 

"Liberty  Bonds";  if  carried  out,  this  will  constitute  distribu- 
tion of  property  dividends,  since  those  bonds  have  not  been 
made  legal  tender. 

§  76.     Dates  of  Declaration  and  Payment  of  Dividends 

Except  in  the  case  of  guaranteed  stocks^  and  sometimes  of 
cumulative  preferred  stocks,  it  is  not  usual  to  have  charter 
provisions  or  by-lav^s  prescribe  the  intervals  or  dates  at  which 
dividends  shall  be  declared  or  become  payable.  Leading  cor- 
porations have  adopted  the  custom  of  holding  meetings  of 
directors  at  regular  intervals  to  take  action  on  the  declaration 
of  dividends.  These  dates  are  well  known  and  are  anticipated 
on  the  stock  market. 

Dividends  are  payable  to  the  stockholders  of  record,  and 
in  order  that  a  correct  list  of  these  may  be  made,  it  is  neces- 
sary, especially  for  the  larger  corporations  whose  shares  are 
actively  traded  in,  to  fix  an  interval  of  one  or  more  days  dur- 
ing which  no  transfers  can  be  recorded.  This  interval  will 
immediately  precede  the  date  of  dividend  payments  and  the 
corporation  upon  announcing  the  declaration  of  dividends  will 
also  announce  by  letter  or  public  advertisement  the  dates  of 
closing  and  reopening  of  the  stock  transfer  books.  Stock 
sold  in  the  interim  is  usually  sold  "dividend  off,"  or  "ex-divi- 
dend," meaning  that  the  buyer  is  not  entitled  to  the  next 
dividend  which  will  go  to  the  transferor  as  the  stockholder  of 
record.  The  rules  of  the  New  York  Stock  Exchange  pro- 
vide that  all  cash  sales  of  stock  of  a  corporation,  the  closing 
of  whose  books  has  been  announced,  made  on  the  day  and  up 
to  the  time  officially  designated  for  the  closing  of  the  books 
shall  be  made  "dividend  on,"  certificates  being  delivered  on 
that  same  day  rather  than  the  following  day,  as  is  the  usual 
custom,  so  that  buyers  may  be  able  to  get  transfers  recorded. 
All  transactions  on  that  day  other  than  for  cash,  and  all  trans- 
actions in  the  interim  while  books  remain  closed,  are  made 
"ex-dividend." 


Part  III— Funded  Debt 


CHAPTER    VIII 
BONDS,   TRUST    DEEDS,    AND    MORTGAGES 

§  77.     Corporate  Borrowing 

Modern  financial  organization  has  little  place  for  the  time- 
worn  injunction:  "Neither  a  borrower  nor  a  lender  be." 
Wealth  increases  only  as  it  is  utilized,  and  to  a  greater  or 
less  extent  the  rate  of  increase  depends  upon  the  amount  of 
wealth  put  out  for  increase,  although  every  business  has  its 
point  of  saturation  beyond  which  additional  capital  will  not 
produce  as  great  a  return  as  that  before  invested.  Suppose  a 
firm  with  a  total  capital  of  $50,000  contributed  by  its  mem- 
bers finds  that  it  can  double  its  earnings  by  doubling  its  capi- 
tal, i.e.,  can  use  an  additional  $50,000  in  its  business  and  earn 
10  per  cent  thereon.  It  will  do  well,  if  this  is  the  case,  to 
borrow  the  additional  capital.  If  it  borrows  $50,000  at  6  per 
cent,  the  business  will  yield  to  the  members  of  the  firm  a  re- 
turn of  14  per  cent  instead  of  10  per  cent  on  their  contribu- 
tion, while  the  contributors  of  the  loan  capital  will  receive 
their  6  per  cent,  presumably  a  fair  return  on  their  investment 
made  under  conditions  of  safety  and  other  considerations  of 
paramount  importance  to  them.  In  this  instance,  the  borrow- 
ing firm  is  "trading  on  the  equity,"  a  term  which  has  been  bor- 
rowed from  England. 

It  is  upon  this  principal  of  finance  that  the  practice  of 
borrowing  capital  for  the  purpose  of  developing  and  conduct- 
ing corporate  enterprises  has  become  so  well  established. 
Concurrently  with  the  extension  of  the  practice  of  utilizing 
borrowed  capital  in  corporate  enterprises  came  an  increase  in 

147 


148  FUNDED    DEBT 

the  amount  of  money  ready  for  loan  in  the  hands  of  bankers, 
insurance  companies,  savings  banks,  and  similar  institutions 
which  had  developed  practical  methods  of  bringing  together 
and  making  available  in  large  sums  the  small  surplus  capital 
of  many  persons.  These  financial  corporations  took  a  position 
intermediate  between  the  owners  of  capital  and  those  making 
use  of  that  capital  in  productive  enterprises.  The  necessity  for 
these  intermediaries  has  been  twofold ;  first,  they  could  offer 
more  elements  of  security  to  their  immediate  capital-owning 
clients,  and  second,  dealing  with  amounts  larger  than  the  in- 
dividual capital  owners  could  command,  they  could  make  more 
advantageous  bargains  both  as  to  rate  of  interest  and  security 
of  principal. 

§78.     "Loan  Capital" 

The  total  capital  of  a  corporation  which  has  traded  on 
the  equity  consists  of  "share  capital,"  representing  the  con- 
tributions of  those  who  have  invested  their  money  primarily  in 
the  enterprise  of  the  corporation,  and  "loan  capital,"  repre- 
senting the  contributions  of  those  who  have  invested  primarily 
in  a  loan  and  only  secondarily  in  the  enterprise  of  the  cor- 
poration. 

Similarly  to  the  authorization  of  share  capital,  authority 
for  the  acquisition  of  capital  on  loan  must  be  found  in  the 
charter  of  the  corporation.  In  this  respect  the  rights  and 
duties  of  the  corporation  need  the  clearest  possible  definition 
and  regulation,  for  the  integrity  of  "loan  capital,"  in  view  of 
the  limited  and  impersonal  liability  of  the  corporation,  is  more 
essential  as  a  matter  of  public  policy  than  that  of  the  share 
capital.  Authority  for  a  corporation  to  borrow  money  and 
contract  debts  "when  necessary  for  the  transaction  of  its 
business,  or  for  the  exercise  of  its  corporate  rights,  privileges, 
or  franchises,  or  for  other  lawful  purposes  of  its  incorpora- 
tion," ^  is  contained  in  general  incorporation  laws;  it  thus 


*  Quotation   from   New  York  statute. 


BONDS,    TRUST    DEEDS,   AND    MORTGAGES         149 

becomes  one  of  the  incidental  powers  (distinguished  from  the 
specific  powers  to  be  enumerated  in  the  certificate  of  incor- 
poration) of  every  corporation. 

A  corporation  has  its  legal  residence  in  the  state  wherein 
incorporated,  and  the  laws  of  that  state  control  the  exercise 
of  the  right  to  borrow.  If  certificates  of'  indebtedness  issued 
by  the  corporation  are  valid  in  that  state)  they  are  valid  every- 
where else.  Corporations  are  often  incorporated  in  more  than 
one  state;  then,  if  the  indebtedness  is  valid  in  any  one  state, 
it  is  valid  in  the  others  as  well. 

§  79.     Funded  and  Unfunded  Debt 

Debts  incurred  for  the  purpose  of  acquiring  capital  funds 
are  usually  for  long  periods,  and  the  interest  obligations  be- 
come fixed  charges  against  the  income  of  the  corporation  for 
many  years.  Hence,  such  debt  is  variously  termed  "funded" 
or  "permanent"  debt.  To  distinguish  between  funded  and 
unfunded  debt  is  not  always  easy  without  some  arbitrary  rule. 
The  rule  which  has  found  general  acceptance  classifies  as 
"funded"  all  debt  maturing  more  than  one  year  after  its 
creation,  all  other  debt  being  classified  as  "unfunded."  Here 
permanency  is  the  only  determining  factor,  and  the  line  of 
division  corresponds  to  that  between  fixed  and  floating  capital. 
Under  this  rule,  the  instructions  of  the  Public  Service  Com- 
missions of  New  York  classify  as  "unfunded  debt"  that  which, 
though  originally  "funded,"  has  since  matured  but  remains 
outstanding;  in  other  words,  overdue  funded  debt,  whether  it 
remains  overdue  by  agreement  between  the  parties  or  in- 
ability of  the  borrower  to  meet  payment,  is  to  be  classified  as 
"unfunded."  If  the  purpose  of  the  rule  is  to  afford  some 
basis  of  apportioning  the  debt  of  the  corporation  between  that 
presumably  incurred  for  fixed  capital  purposes,  and  that  in- 
curred for  floating  capital  purposes,  the  instructions  do  not 
appear  to  be  logical,  since  the  fact  of  maturity  does  not  ipso 
facto  work  a  change  in  the  purpose  for  which  the  debt  was 


150  FUNDED   DEBT 

originally  incurred.  In  theory,  to  be  sure,  the  basis  of  the 
rule  is  strictly  logical,  for  it  is  supposed  that  debt  having  a 
period  of  maturity  will  be  provided  for  out  of  earnings  during 
the  life  of  the  bonds,  and  that  upon  the  maturity  of  the  debt 
it  ceases  to  represent  fixed  capital,  its  place  being  taken  by  the 
accumulated  earnings  which  are  to  wipe  out  the  debt.  On  the 
other  hand,  debt  representing  moneys  borrowed  to  serve  as 
loan  capital  is  ordinarily  intended  to  be  permanent,  and  the 
fact  of  maturity  is  only  an  incident;  upon  maturity  the  cer- 
tificates evidencing  the  debt  may  be  changed  but  the  debt  itself 
will  continue;  no  provision  is  therefore  made  actually  to  pay 
the  amount  of  the  debt,  which  is  simply  refunded.  It  would 
be  rather  anomalous  to  show  instead  of  funded  debt  a  large 
amount  of  unfunded  debt  at  the  particular  instant  when  the 
old  debt  having  matured  is  carried  over,  pending  the  actual 
refunding  by  a  new  issue. 

This  distinction  between  funded  and  unfunded  debt  has 
been  carried  into  the  public  utility  laws  of  all  the  states,  regu- 
lation being  practically  confined  to  debt  maturing  more  than 
one  year  from  the  date  of  its  creation.  The  Public  Service 
Commissions  Law  of  New  York  requires  the  consent  of  the 
Commissions  to  the  issue  of  "notes,  or  other  evidences  of  in- 
debtedness payable  at  periods  of  more  than  twelve  months 
after  the  date  thereof."  But  corporations  "may  issue  notes, 
for  proper  corporate  purposes  and  not  in  violation  of  any  pro- 
vision of  this  chapter  or  any  other  act,  payable  at  periods  of 
not  more  than  twelve  months,  without  such  consent,  but  no 
such  notes  shall,  in  all  or  in  part,  directly  or  indirectly,  be 
refunded,  by  any  issue  of  stock  or  bonds,  or  by  any  evidence 
of  indebtedness  running  for  more  than  twelve  months  with- 
out the  consent  of  the  proper  commission."  This  does  not 
prohibit  the  renewing  of  such  notes  from  year  to  year;  the 
statutes  of  one  or  two  other  states,  however,  do  proliibit  the 
renewal  of  such  obligations  without  the  consent  of  the  com- 
mission.     Propositions   have   also   been   made   to   limit   the 


BONDS,   TRUST   DEEDS,   AND   MORTGAGES         151 

amount  of  unfunded  debt  which  may  be  incurred  without 
public  authority  to  a  certain  percentage  of  the  authorized 
funded  debt. 

§  80.     Corporate  Bond  Issues 

Just  as  any  individual  may  borrow  money  from  a  bank  or 
from  other  persons  on  his  notes,  so  also  may  the  corporation. 
As  a  matter  of  fact,  many  corporations  do  borrow  constantly 
from  these  sources  to  meet  their  current  and  temporary  obli- 
gations, and  the  banking  relationships  of  many  large  railroad 
and  other  corporations  are  very  intimate  and  important;  so 
much  so  that  federal  statutory  regulation  has  been  enacted. 
Many  small  and  purely  local  corporations  are  practically 
limited  to  these  sources  in  borrowing  capital.  This  method, 
however,  is  not  open  to  corporations  contemplating  an  enter- 
prise of  some  magnitude  and  expecting  to  borrow  capital 
funds  from  a  number  of  sources.  Out  of  the  attempt  to 
borrow  large  amounts  for  long  periods,  and  to  interest  a  great 
many  lenders,  there  has  been  evolved  the  system  of  corporate 
bond  issues  as  it  is  now  known. 

The  issue  of  capital  stock,  its  par  value,  the  nature  and 
amount  of  consideration  to  be  received  therefor,  the  method 
of  making  valid  subscriptions,  etc.,  have  been  covered  by 
statute  ever  since  general  incorporation  laws  were  enacted, 
but  the  issue  of  bonds  has  not  been  similarly  covered.  Beyond 
the  alm.ost  incidental  reference  to  the  fact  that  a  corporation 
might  borrow  money  "for  the  transaction  of  its  business  or 
for  other  lawful  purposes  of  its  incorporation,"  statutory  regu- 
lations covering  the  issue  of  bonds  have  been  almost  wholly 
lacking,  save  for  some  general  provisions  that  the  aggregate 
amount  of  bonds  should  not  exceed  a  given  proportion  of  capi- 
tal stock  or  property  values.  It  has  been  only  recently  that  a 
proper  measure  of  restrictive  and  definitive  regulation  of  cor- 
porate borrowing  has  been  introduced.  In  the  future  these 
safeguards  for  the  investor  are  likely  to  be  much  extended. 


152 


FUNDED    DEBT 


§  8i.     Bonds  and  Notes 

Money  obligations  are  usually  evidenced  bv  instruments  in 
writing — promissory  notes,  bills,  etc.  All  such  instruments 
come  within  the  general  term  "bonds,"  e.g.,  the  bond  accom- 
panying a  mortgage.  When  used  in  relation  to  corporate 
debts,  however,  the  word  "bond"  has  come  to  have  a  special 
meaning,  denoting  the  evidence  certifying  a  funded  debt  obli- 
gation, usually  one  of  a  series,  each  of  the  same  par  value, 
interest-bearing,  with  the  principal  of  the  debt  payable  at  a 
time  and  under  the  conditions  recited  in  the  instrument. 
These  bonds  may  be  negotiable  or  non-negotiable.  A  ne- 
gotiable bond  is  essentially  a  promissory  note,  but  more  elabor- 
ate in  form  and,  in  addition  to  the  usual  recital  of  a  promis- 
sory note,  contains  special  terms  descriptive  of  the  rights  of 
debtor  and  creditor.  Then  there  is  a  class  of  corporate  funded 
debt  designated  "notes."  That  term,  so  used,  implies  an  obli- 
gation maturing  within  a  comparatively  short  period,  while 
bonds  cover  a  longer  period.  As  these  short-term  obligations 
are  most  usually  unsecured  by  collateral  or  mortgage,  an  ex- 
tension of  the  accepted  meaning  may  bring  within  the  term 
"notes"  all  unsecured  notes  or  obligations,  and  within  the 
meaning  of  "bonds"  all  secured  funded  debt  obligations. 

§  82.     Bonds  and  Stocks 

A  bond  is  a  promise  to  pay  a  sum  certain  in  money  at  a 
specified  date;  capital  stock  is  a  promise  to  divide  corporate 
assets.  The  issue  of  a  bond  creates  the  relationship  of  debtor 
and  creditor ;  the  issue  of  capital  stock  adds  to  or  further  dis- 
tributes proprietorship.  A  bond  expresses  a  par  value  which 
is  the  measure  of  corporate  liabiHty;  a  share  of  stock  ex- 
presses a  par  value  which  is  merely  nominal,  indicating  no 
liabiHty  save  that  of  apportioning  to  it  a  share  of  the  cor- 
porate assets,  and  it  is  more  of  an  evidence  of  a  sum  of  money 
received  than  it  is  of  a  sum  of  money  to  be  paid.  The  bond- 
holder receives  interest,  a  payment  for  the  use  of  money;  the 


BONDS,    TRUST    DEEDS,   AND    MORTGAGES  153 

stockholder  receives  dividends,  a  share  of  the  profits  earned 
and  surpkis  assets.  In  actual  practice,  however,  there  are 
many  cases  where  the  distinction  is  not  clear-cut  and  definite, 
where  the  bond  resembles  a  share  of  stock  and  vice  versa. 
For  instance,  there  are  bonds  having  no  date  of  maturity, 
hence  they  are  not  definite  promises  to  pay  sums  certain  in 
money  at  specified  dates.  Their  issue,  therefore,  does  not 
create  the  relationship  of  debtor  and  creditor  except  as  that 
relationship  may  be  created  by  the  happening  of  a  contingency, 
such  as  the  failure  to  pay  interest.  It  may  also  happen  that  a 
bond,  properly  so  called,  draws  no  interest  and  is  entitled  to 
share  only  in  the  distribution  of  earning  if  such  a  distribu- 
tion is  possible.    These  issues  rest  on  the  border  line. 

§  83.     Par  Value  of  Bonds^ 

Just  as  the  total  share  capital  is  divided  into  small  units, 
so  is  the  loan  capital,  but  usually  not  into  as  small  units.  Up 
to  a  short  time  ago  the  customary  par  value  of  bonds  was 
$1,000.  There  were  some  of  $500,  but  very  few  of  less 
amount.  There  were  many  reasons  for  making  the  par  value 
of  a  bond  greater  than  that  of  a  share  of  stock.  In  many 
issues  a  separate  certificate  must  be  executed  for  each  bond, 
while  a  single  certificate  of  stock  may  convey  any  number  of 
shares.  For  this  reason,  placing  the  par  value  of  bonds  at  a 
higher  figure  meant  economy,  not  only  in  the  original  cost 
of  preparing  certificates  but  also  in  the  handling  of  sales  and 
the  labor  of  interest  payments. 

A  corporation  which  expects  to  find  a  ready  market  for  its 
bonds  among  capitalists  will  still  continue  to  place  the  par 
value  of  these  bonds  at  $500  or  $1,000,  some  going  as  high 
as  $5,000  and  $10,000.  Of  late  years  in  an  effort  to  increase 
the  market  for  bonds  and  to  interest  in  their  purchase  men  of 


^  The  author  uses  the  term  "par  value"  as  relating  to  bonds  in  deference  to  the 
common  usage;  a  more  appropriate  term,  and  one  which  is  beginning  now  to  be  more 
generally  used,  is  "face  value."  "Par  value"  is  not  i:sed  in  connection  with  ordinary- 
promissory  notes,  either  in  common  or  legal  phraseology,  and  since  the  bond  is  only  a 
form  of  promissory  note  there  seems  to  be  no  good  reason  for  a  different  terminology. 


154 


FUNDED    DEBT 


small  means,  "baby"  bonds  of  $ioo  par  value  have  been  intro- 
duced upon  the  market.  In  the  view  of  many  bankers  and 
investment  houses  these  bonds  find  a  ready  market  and  are 
said  to  be  in  demand.  Their  issue  involves,  of  course,  a 
greater  expense  to  the  corporation  issuing  them,  but  it  may  be 
that  the  increased  expense  is  offset  by  a  more  advantageous 
price  realized  because  of  their  easier  marketability. 

In  the  case  of  registered  bonds,  described  in  §  89,  the 
par  value  is  placed  at  $1,000,  $5,000,  or  other  multiples  of 
$1,000,  and  a  single  registered  bond  may  be  equivalent  to  a 
number  of  coupon  bonds. 

§  84.     Security  for  Funded  Debt 

Corporate  borrowing  on  a  large  scale  is  possible  since 
many  persons  would  rather  invest  in  a  loan  to  the  corporation 
than  in  its  shares  of  stock,  because  they  want  certain  assur- 
ances to  surround  their  investment.  The  most  important  of 
these  assurances  is  that  of  security — a  guaranty  that  the  in- 
vestment will  be  protected,  that  principal  and  interest  will  be 
paid  according  to  agreement.  These  assurances  may  be  wholly 
intangible  if  the  faith  of  the  lender  in  the  stability  of  the 
corporate  enterprise  and  its  integrity  is  so  great  as  to  assure 
him  of  security.  A  corporation  which  is  engaged  in  a  stable 
business,  and  has  been  in  operation  for  a  period  sufficiently 
long  to  have  acquired  a  reputation  for  soundness  of  condition 
and  efficiency  of  management,  can  often  borrow  capital  upon 
its  credit  alone.  Because  of  its  standing  and  the  availability 
of  sufficient  assets  to  meet  its  obligations  at  any  time,  loans 
resting  simply  upon  its  corporate  credit  may  be  as  safe  as 
loans  made  under  the  best  of  conditions  can  be.  But  such 
loans  are  not  spoken  of  as  secured.  Only  such  loans  are 
secured  as  are  supported  by  a  lien  upon  property,  real  or  per- 
sonal, so  that  upon  default  the  debt  may  be  satisfied  by  the  ap- 
plication of  valuable  property  or  proceeds  derived  from  the 
sale  thereof.     Thus,  funded  debts  are  broadly  divided  into 


BONDS,   TRUST    DEEDS,    AND    MORTGAGES  155 

secured  and  unsecured.  Unsecured  funded  debt  is  the  excep- 
tion to  the  rule ;  it  is  possible  only  to  companies  of  strong 
credit.  The  market  for  unsecured  funded  debt  is  very  limited 
indeed,  since  many  individuals  and  institutions,  such  as  trus- 
tees, savings  banks,  insurance  companies,  etc.,  which  control 
the  greatest  portion  of  money  available  for  loan,  are  restricted 
by  law  to  investments  in  secured  funded  debt. 

The  lien  of  a  debt  upon  property  of  the  debtor  is  created 
either  by  operation  of  law,  e.g.,  mechanics'  liens,  etc.,  or  by 
private  contract.  The  contract  may  be  one  of  mortgage  or 
pledge,  depending  upon  the  nature  of  the  property  upon  which 
the  lien  is  imposed.  A  mortgage  relates  to  security  consist- 
ing of  real  property,  or  real  and  personal  property  mixed,  or, 
if  it  is  a  chattel  mortgage,  to  personal  property  alone ;  a  pledge 
relates  only  to  security  consisting  of  personal  property,  and 
possession  goes  to  the  pledgee. 

The  distinction  between  a  chattel  mortgage  and  a  pledge 
may  be  stated  thus:  A  chattel  mortgage  transfers  the  title 
in  the  thing  mortgaged  to  the  mortgagee,  with  a  condition 
that  if  the  mortgagor  performs  the  promise  for  the  assurance 
of  which  the  mortgage  is  given,  the  sale  shall  become  void  and 
the  title  reinvested  in  the  mortgagor,  who,  in  the  meantime, 
retains  possession.  A  pledge  leaves  the  title  of  the  pledgor 
undisturbed,  but  transfers  possession  to  the  pledgee  subject  to 
an  agreement  that  the  latter  will  surrender  possession  when  the 
pledgor  performs  the  promise  intended  to  be  assured  by  the 
making  of  the  pledge. 

§  85.     Mortgages  and  Deeds  of  Trust 

A  mortgage  is  a  contract  by  which  specific  property  is  con- 
veyed by  way  of  pledge  to  secure  the  payment  of  a  debt  or 
the  performance  of  some  other  act.  In  form  it  is  an  absolute 
conveyance  of  the  property  to  which  it  relates,  and  transfers 
the  legal  title  to  the  mortgagee  until  such  time  as  the 
mortgagor  may  demand  the  reinvestiture  of  title  in  himself  by 


156 


FUNDED   DEBT 


performing  the  act  or  paying  the  debt  according  to  the  terms 
of  the  agreement  out  of  which  the  mortgage  arose.  In  actual 
fact  it  is  not  an  absolute  conveyance  of  an  estate  or  interest 
in  the  property  covered,  but  simply  a  lien  thereon.  The 
mortgagor  remains  the  actual  owner  and  exercises  all  of  the 
rights  of  ownership  until  default,  when  his  rights  may  be 
foreclosed  by  judicial  decree  or  by  the  express  terms  of  the 
mortgage. 

The  debt  which  has  been  secured  by  mortgage  is  evidenced 
by  a  bond.  The  evidence  of  the  debt  and  the  security  for  the 
debt  constitute  the  "bond  and  mortgage."  The  debt  is  the 
principal  thing,  the  security  is  only  an  incident  of  the  debt; 
thus  there  may  be  a  bond  without  a  mortgage,  but  there  can- 
not be  a  mortgage  without  a  bond.  A  mortgage  may  fail  or 
be  void  without  vitiating  the  indebtedness  upon  the  bond,  but 
if  the  bond  should  fail  or  be  void,  the  mortgage  will  also  fail. 
If  the  interest  upon  the  debt,  or  any  part  of  the  principal, 
should  remain  unpaid  after  it  is  due,  the  creditor  may  exercise 
his  claim  upon  the  property  and  through  proper  proceedings 
have  it  applied  to  the  satisfaction  of  his  claim.  In  thus  secur- 
ing the  property  to  himself  or  exercising  his  lien  thereupon, 
he  does  not,  however,  surrender  any  part  of  his  claim  upon 
the  bond  against  the  debtor.  If  the  proceeds  of  the  sale  of 
the  property  are  insufficient  to  discharge  the  debt,  the  creditor 
may  secure  judgment  against  the  debtor  for  the  deficiency  and 
have  execution  issued  against  any  other  property  he  may  own. 

The  ordinary  form  of  bond  and  mortgage,  while  adequate 
for  transactions  between  individuals,  is  not  adapted  to  a  situa- 
tion where  there  are  a  number  of  lenders  and  one  borrower 
upon  the  security  of  one  group  of  properties.  It  is  impossible 
to  execute  an  individual  indenture  of  mortgage  to  each  per- 
son; hence  corporate  mortgages  are  executed  in  favor  of  third 
parties,  "trustees,"  who  hold  the  property,  i.e.,  the  legal  title, 
in  trust  for  the  securing  of  the  obligations  to  be  met,  posses- 
sion remaining  in  the  mortgagor  until  defeasance.    A  corpor- 


BONDS,   TRUST   DEEDS,   AND    MORTGAGES  157 

ate  mortgage  thus  differs  from  the  ordinary  mortgage  in  that 
it  not  only  effects  the  transfer  of  property  for  the  securing  of 
debts  but  is  also  an  instrument  creating  a  trust.  It  is  there- 
fore variously  designated  a  "trust  mortgage,"  "deed  of  trust," 
"trust  deed,"  or  "mortgage  deed  of  trust." 

The  power  to  mortgage  is  closely  related  to  the  power  to 
sell ;  hence  a  mortgage  covering  real  property  is  governed  by 
the  laws  of  the  state  where  the  property  is  located  and  not 
where  the  company  is  incorporated.  Such  a  mortgage  is  re- 
quired to  be  recorded,  usually  in  the  office  of  the  clerk  of  the 
county  wherein  the  property  is  located.  In  the  case  of  rail- 
road corporations  some  states  have  special  provisions  which 
permit  filing  with  the  Secretary  of  State  in  lieu  of  filing  in 
each  county  through  which  the  road  passes. 

Railroads  and  public  utilities  are  held  not  to  possess  the 
unrestricted  right  to  mortgage  their  properties  in  the  same  way 
that  individuals  possess  the  right.  The  reason  for  this  is  that 
the  exercise  of  creditors'  rights  to  be  thereby  created  may 
bring  about  foreclosure  and  sale  of  the  property,  interfering 
with  operations  and  even  causing  their  complete  abandonment. 
Having  accepted  a  franchise  carrying  a  public  duty,  they  must 
continue  to  administer  that  duty  and  cannot  by  their  own 
volition  resign  therefrom  or  cause  it  to  fail  through  any 
device  whatever.  Hence,  although  in  dealing  with  the  prop- 
erty the  corporation  will  need  to  observe  especially  the  laws  of 
the  state  in  which  the  property  is  located,  the  laws  of  the 
state  of  its  incorporation  will  also  be  controlling  by  reason  of 
their  influence  upon  the  general  powers  exercised  by  the 
corporation. 

The  deed  of  trust  executed  by  a  large  public  utility  or  rail- 
road corporation  is  a  very  formidable  document  which  some- 
times runs  into  hundreds  of  printed  pages.  It  is  not  the  pur- 
pose of  this  book  to  go  into  detail  as  to  the  construction  of  a 
mortgage  or  deed  of  trust,  and  only  its  principal  features  are 
discussed  herein. 


I^g  FUNDED   DEBT 

§  86.  Parties  to,  and  Authority  for,  Execution  of  Trust  Deed 
The  parties  to  the  deed  of  trust  are  the  corporation  execut- 
ing it  and  the  trustee.  The  bondholders  are  not  a  party  to 
the  agreement  at  all,  but  throughout  the  instrument  the 
promises  to  pay  are  in  favor  of  "the  holder  or  the  registered 
owner,  as  the  case  may  be,  of  every  bond  issued  and  secured 
hereunder."  Title  is  conveyed  to  the  trustee  "in  trust,  never- 
theless, for  the  use,  benefit  and  security  of  the  Trust  Com- 
pany, as  Trustee,  for  the  equal  and  ratable  use  and  benefit  of 
all  and  every  one  of  the  persons,  firms,  or  corporations,  who, 
or  which,  shall  become  or  be  the  holders  of  the  bonds  intended 
to  be  secured  hereby." 

The  authority  for  the  execution  of  the  deed  of  trust  is  set 
forth  at  the  beginning  of  the  instrument.  The  resolution  of 
the  board  of  directors,  describing  the  circumstances  under 
which  and  the  purposes  for  which  the  bonds  are  to  be  issued 
and  the  mortgage  executed,  is  copied  in  full,  followed  by 
reference  to  the  consent  of  stockholders  duly  given.  Where 
the  specific  authorization  of  a  state  or  governmental  authority 
is  also  required,  the  fact  that  it  has  been  procured  is  always 

stated. 

• 

§  87.     The  Bond  Agreement 

The  bond  is  an  agreement  complete  in  itself.  When  the 
corporation  executes  and  issues  a  bond,  it  makes  a  definite 
promise  to  pay  the  amount  of  that  particular  bond  in  accord- 
ance with  the  terms  expressed  therein.  In  the  case  of  un- 
secured bonds,  each  one  would  be  complete  in  itself  and 
subject  to  no  limitation  upon  the  bondholder's  right  to  claim 
payment  upon  maturity.  The  same  is  true  concerning  the 
obligation  upon  a  secured  bond;  the  security  of  the  latter, 
however,  extends  to  the  entire  issue,  and  the  conditions  and 
the  provisions  of  the  mortgage  limit  the  individual  bond- 
holder's right  to  resort  to  the  security  for  the  satisfaction  of 
his  claim.     These  also  restrict  the  choice  of  the  company  to 


BONDS,   TRUST    DEEDS,   AND   MORTGAGES  159 

pay  some  of  the  bonds  without  paying  all  others  of  like  rank 
and  maturity.  These  conditions  and  provisions  are  not  set 
out  in  full  in  the  text  of  the  bond,  but  are  incorporated  in  the 
agreement  by  specific  reference  to  the  mortgage  or  deed  of 
trust  in  which  they  are  to  be  found.  In  this  way  the  bond- 
holder is  charged  with  knowledge  of,  and  held  to,  all  of  these 
conditions  and  provisions.  The  bond  agreement  recites  that: 
"This  bond  is  one  of  a  series,  of  like  tenor  and  date,  numbered 
consecutively  from  one  upward,  issued  and  to  be  issued  under 
and  in  pursuant  of,  and  all  equally  secured  without  priority 

or  preference  by  a  mortgage  or  deed  of  trust  to  the  , 

Trust  Company,  of  New  York,  bearing  even  date  herewith,  of 
all  the  line  of  railroad  of  said  Railroad  Company  now  built  or 
to  be  built,  and  the  franchises  authorizing  the  construction  and 
operation  thereof  now  owned  or  hereafter  to  be  acquired,  as 
therein  set  forth." 

On  the  other  hand,  the  bond  agreement  is  set  forth  in  the 
mortgage  and  becomes  an  inherent  part  of  it,  so  that  failure 
to  perform,  or  improper  performance  of  the  several  parts  of 
the  bond  agreement,  will  entitle  the  trustee  to  proceed  against 
the  property  which  comprises  the  security.  It  is  necessary  that 
the  bond  agreement  be  incorporated  in  the  mortgage,  for  no 
mortgage  can  exist  without  a  bond,  while,  as  already  stated, 
a  bond  may  exist  without  a  mortgage. 

The  steps  to  be  taken  preliminary  to  the  issue  of  the  bonds 
to  render  them  valid  evidences  of  indebtedness  or  to  bring 
them  within  the  operation  of  the  trust  deed,  the  manner  in 
which  the  conditions  of  the  bond  agreement  shall  be  per- 
formed, the  acts  or  omissions  which  will  be  deemed  to  con- 
stitute breaches  of  its  covenants,  and  the  rules  which  shall 
govern  resort  to  the  security  for  the  satisfaction  of  the  com- 
pany's promises,  are  minutely  described  in  the  trust  deed. 

The  promise  to  pay  is  divisible  into  two  parts,  the  pay- 
ment of  principal  and  the  payment  of  interest.  The  security 
for  both  is  the  same;  so  also  the  medium  of  payment,  e.g.,  "in 


j6o  funded  debt 

gold  coin."  It  is  also  usually  provided  that  the  principal  and 
interest  are  "payable  without  any  deduction  for  any  tax  or 
taxes  which  the  company  may  be  required  to  pay  or  to  retain 
therefrom,  under  any  present  or  future  law  of  the  United 
vStates,  or  of  any  State  or  County,  or  municipality  thereof." 
The  force  and  effect  of  these  provisions  are  further  discussed 
in  §  104. 

Permanent  certificates,  usually  engraved,  are  designated 
as  "definitive"  bonds.  Pending  the  preparation  of  these  cer- 
tificates temporary  bonds  may  be  issued.  The  recital  and 
effect  of  the  temporary  certificates  are  substantially  the  same 
as  those  of  the  permanent  bond,  and  they  are  signed,  authenti- 
cated, and  certified  in  like  manner,  but  bear  a  notation  that 
they  are  temporary  certificates  exchangeable  for  a  like  number 
of  permanent  bonds. 

Ordinarily  the  mortgage  specifies  the  aggregate  amount  of 
the  bond  issue  to  be  put  out;  if  it  does  not  limit  the  issue  to 
any  specified  amount,  it  is  spoken  of  as  an  "open"  mortgage. 
After  the  entire  aggregate  amount  of  the  issue  has  been  put 
out,  the  mortgage  is  "closed";  but  if  only  a  part  has  been  put 
out,  the  remainder  to  be  issued  from  time  to  time  and  as  occa- 
sion may  demand,  the  mortgage  is  "open-end." 

§  88.     Parties  to  the  Bond  Agreement 

As  in  every  agreement  which  is  to  be  complete  in  itself,  the 
bond  agreement  must  identify  the  parties  thereto.  The  parties 
to  this  agreement  are  different  from  those  to  the  mortgage  or 
deed  of  trust.  The  latter  is  between  the  corporation  and  the 
trustee,  with  only  collateral  reference  to  the  bondholder.  The 
bond  is  an  agreement  between  the  corporation  and  the  owner 
of  the  bond,  with  only  collateral  reference  to  the  trustee. 

The  identity  of  the  obligor  is  sufficiently  indicated  by  the 
designations:     "Know  all  men  by  these  presents.  That  the 

Company,  a  corporation  organized  and 

existing  under  the  laws  of  the  State  of  New  York,  for  value 


BONDS,   TRUST    DEEDS,   AND    MORTGAGES  i6l 

received,  promises  to  pay,"  etc.  To  be  a  valid  instrument, 
however,  the  certificate  must  contain  the  signature  of  certain 
officers  and  bear  the  corporate  seal.  The  signatures  required 
are  indicated  in  the  witnessing  clause  of  the  bond,  and  are  also 
covered  by  provisions  in  the  deed  of  trust.    The  last  clause  of 

the  bond  recital  will  read:    "In  witness  whereof,  the 

Company  has  caused  these  presents  to  be  signed  by 

its  President  or  one  of  its  Vice-Presidents,  and  its  corporate 
seal  to  be  hereunto  affixed,  and  to  be  attested  by  its  Secretary 
or  Treasurer  or  an  Assistant  Secretary  or  an  Assistant  Treas- 
urer, all  in  the  City  of  New  York,"  etc.  It  is  usually  provided 
that  the  engraved  fac-simile  signature  of  the  treasurer  shall 
be  sufficient  certification  of  the  interest  warrants. 

The  definiteness  with  which  the  obligee  or  payee  is  de- 
scribed depends  upon  the  form  of  the  bond;  if  it  is  a  coupon 
bond,  the  payee  is  not  named  at  all,  while  if  it  is  a  registered 
bond,  the  payee  is  designated  by  name. 

The  trustee  is  not  a  party,  but  his  certification  upon  the 
bond  is  very  frequently  required,  in  which  case  the  bond 
recites:  "This  bond  shall  be  valid  only  when  authenticated  by 
a  certificate  indorsed  hereon,  signed  by  the  said  Trust  Com- 
pany, Trustee  under  said  mortgage  or  Deed  of  Trust."  The 
certification  is  merely  to  the  effect  that  "this  is  one  of  the 
bonds  issued  under  the  mortgage  or  trust  deed  bearing  date  of 
referred  to  therein." 

§  89.     Coupon  and  Registered  Bonds 

Classified  as  to  form,  bonds  are  of  two  main  classes: 
coupon  bonds  and  registered  bonds. 

A  coupon  bond  recites  that  the  obligor  "for  value  received, 
hereby  promises  to  pay  to  bearer."  The  owner  of  the  bond  is 
not  named  at  all,  and  title  to  the  bond  passes  by  delivery  of  the 
certificate.  Each  bond  is  evidenced  by  a  separate  certificate; 
each  one  is  complete  in  itself  and  not  divisible  into  parts  for 
the  purposes  of  transfer.    The  coupon  bond  has  attached  to  it 


l62  FUNDED    DEBT 

what  are  in  effect  separate  promissory  notes  representing  the 
periodic  interest  accruals.  As  each  interest  date  comes  around, 
one  of  these  coupons  must  be  "cHpped"  and  presented  to  the 
corporation  or  its  designated  fiscal  agent  for  payment.  These 
coupons  are  payable  to  bearer. 

A  registered  bond  recites  that  the  obligor  "for  value  re- 
ceived, hereby  promises  to  pay or  assigns, 

Thousand  Dollars,"  etc.  Thus,  the  bond  identifies  its  owner 
by  name,  and  record  of  that  ownership  is  made  on  the  books 
kept  for  that  purpose  at  the  office  of  the  corporation  or  its 
fiscal  agents.  As  interest  becomes  due,  it  is  paid  by  check  sent 
direct  to  the  registered  owners.  It  will  be  noted  that  a  place 
is  left  for  the  filling  in  of  the  amount,  so  that  a  registered  bond 
may  be  the  equivalent  in  par  value  of  any  number  of  coupon 
bonds. 

The  title  to  registered  bonds  cannot  be  transferred  without 
an  assignment  in  writing.  The  purchaser  of  the  bond  must 
then  present  his  bond,  together  with  the  assignment,  at  the 
transfer  office  of  the  issuing  corporation.  In  respect  to  method 
of  transfer,  registered  bonds  are  comparable  to  certificates  of 
stock. 

If  the  registered  bond  is  indorsed  in  blank,  it  becomes  pay- 
able to  bearer,  but  the  owner  of  the  certificate  last  recorded 
remains  the  owner  so  far  as  the  corporation  is  concerned  and 
receives  the  interest. 

Because  some  investors  prefer  registered  bonds  and  others 
the  coupon  form,  many  corporations  make  the  bonds  inter- 
changeable, that  is,  the  corporation  will  issue  either  registered 
or  coupon  bonds,  and  upon  the  request  of  any  bondholder  will 
exchange  his  coupon  bonds  for  registered,  or  vice  versa.  If 
convertible  either  way,  at  will,  they  are  called  interchangeable 
bonds.  Where  both  registered  and  coupon  bonds  are  issued, 
the  forms  of  both  are  set  forth  in  the  deed  of  trust. 

The  registered  bond  is  registered  both  as  to  principal  and 
interest,  that  is  to  say,  the  obligation  as  to  principal  and  inter- 


BONDS,   TRUST    DEEDS,   AND    MORTGAGES  163 

est  is  recognized  only  in  favor  of  the  registered  owner.  A 
combination  of  registered  and  coupon  features  is  made  by  some 
corporations  in  the  issue  of  bonds  registerable  as  to  principal 
only,  called  registered  coupon  bonds.  These  are  ordinary  cou- 
pon bonds  in  form,  but  have  blanks  on  the  back  where  the 
name  of  the  owner  may  be  written  in.  The  corporation  pro- 
vides for  entering  this  name  on  the  record  books  and  the  bonds 
become  registered  as  to  principal,  but  interest  will  continue  to 
be  collected  by  the  presentation  of  coupons.  The  bond  itself 
relates  that  the  obligor  "for  value  received,  hereby  promises 
to  pay  to  the  bearer,  or,  if  registered,  to  the  registered  holder 
of  the  bond,  one  thousand  dollars,"  etc.,  "and  to  pay  interest 

on  said  principal  amount  from  May, ,  at  the  rate  of  5 

per  centum  per  annum,  payable  at on  the  first  day  of 

November  and  May  in  each  year,  upon  presentation  and  sur- 
render of  the  annexed  coupon."  Bonds  registerable  as  to 
principal  only  may  be  converted  into  coupon  bonds  by  indors- 
ing as  payable  to  bearer,  and  recording  upon  the  company's 
books  as  bearer  bonds. 

Some  corporations  have  devised  a  method  of  registering 
both  the  principal  and  the  interest  of  coupon  bonds,  by  pro- 
viding that  the  coupons  may  be  detached  and  left  with  the  cor- 
poration or  its  fiscal  agent,  the  bond  itself  to  be  held  by  the 
owner  with  his  name  indorsed  thereupon,  which  will  also  be 
recorded  on  the  company's  books  as  that  of  the  registered 
owner.  While  the  corporation  has  issued  only  coupon  bonds 
by  this  method,  it  has  also  registered  both  the  principal  and  the 
interest  of  its  coupon  bonds.  By  indorsing  the  same  bond  as 
payable  to  bearer,  and  so  entering  it  on  the  company's  books 
and  reattaching  the  sheets  of  unused  coupons,  the  bond  is  re- 
transformed  into  a  coupon  bond. 

Bearer  bonds  are  transferred  by  delivery  from  hand  to 
hand  without  any  writing,  and  can  thus  be  subject  to  such 
considerations  as  govern  all  negotiable  paper,  provided,  of 
course,  the  other  elements  of  negotiability  also  exist;  to  wit, 


164  FUNDED    DEBT 

that  the  bond  is  an  unconditional  promise  for  the  payment  of  a 
specified  sum  of  money,  payable  at  a  known  or  determinable 
date,  and  that  the  holder  thereof  has  acquired  it  in  good  faith, 
before  maturity,  and  without  knowledge  of  any  claim  which 
would  defeat  or  diminish  recovery  of  the  amount  expressed 
thereupon. 

Coupon  bonds  are  generally  preferable  because  of  their 
comparative  ease  of  transfer,  while  registered  bonds  are  pref- 
erable for  the  safeguarding  of  the  certificates  as  well  as  con- 
venience in  relieving  the  owner  from  the  trouble  of  anticipat- 
ing interest  dates,  clipping  coupons  and  presenting  them  for 
collection.  Persons  who  only  occasionally  purchase  bonds,  or 
purchase  to  hold  them  for  long  periods,  will  not  attach  great 
importance  to  the  difficulties  of  transfer  and  will  value  more 
highly  the  other  features  of  registered  bonds.  The  real  diffi- 
culties of  transfer,  however,  are  not  always  fully  appreciated. 

"Owners  of  registered  bonds  may  find  in  the  comparative 
difficulty  of  transfer  a  greater  disadvantage  than  they  antici- 
pate. It  may  cause  delay  in  selling,  and  especially  such  delay 
in  getting  the  proceeds  of  a  sale  as  to  be  embarrassing.  A 
broker  cannot  safely  sell  until  he  is  certain  there  will  be  no 
difficulty  about  effecting  a  transfer.  The  corporation's  agent 
for  registry,  if  competent,  is  bound  to  be  extremely  careful 
about  his  authority  to  transfer,  and  may  cause  long  delay  in 
effecting  a  delivery  by  insisting  on  better  evidence  than  that 
first  supplied  him.  Procuring  a  transfer  in  the  case  of  settling 
an  estate  always  causes  considerable  trouble.  A  dealer  cannot 
safely  register  a  bond  in  the  name  of  the  purchaser  and  send 
it  forward  with  draft  for  collection.  The  registry  fixes  title, 
and  legal  situations  unknown,  perhaps,  to  the  purchaser  as  well 
as  to  the  dealer,  may  intervene  to  deprive  the  dealer  of  his  lien. 
Very  possibly  before  payment  and  delivery  the  purchaser  may 
die.  In  that  event  a  great  deal  of  trouble  and  long  delay  may 
take  place  before  the  dealer  can  get  paid."  ^ 

*  W.  H.  Lyon:    "Capitalization,"  page  1912. 


BONDS,   TRUST   DEEDS,   AND    MORTGAGES  165 

§  gOi     Property  Subject  to  Mortgage 

A  corporate  mortgage  executed  to  secure  an  issue  of  bonds 
almost  always  covers  both  real  and  personal  property.  It  is 
not  necessary  to  describe  at  length  the  distinction  between  these 
two  classes  of  property.  A  satisfactory  classification  is  often 
very  difficult  without  the  application  of  more  or  less  arbitrary 
rules.  The  road,  track,  and  buildings  of  a  railroad  are  real 
estate;  its  rolling  stock,  and  station  and  other  equipment  are 
personal  property.  There  have  been  rulings,  however,  to  the 
effect  that  the  rolling  stock  constituted  fixtures  upon,  and  were 
thus  included  within  real  estate ;  similarly,  while  the  buildings, 
stations,  conductor  lines,  pipes,  or  conduits  of  an  electrical  or 
gas  company  constitute  real  estate,  much  of  the  machinery  and 
plant  constitute  personal  property. 

A  mortgage  covering  real  property  alone  is  a  real  estate 
mortgage;  one  covering  persona^  property  alone  is  a  chattel 
mortgage.  Mortgages  on  real  property  must  be  filed  separately 
from  those  on  personal  property,  and  those  covering  both 
classes  of  property  must  be  filed  twice — once  as  a  real  estate 
mortgage  and  once  as  a  chattel  mortgage.  These  provisions 
have  beeu  generally  amended,  however,  in  respect  of  mortgages 
executed  to  secure  an  issue  of  bonds,  so  that  if  they  cover  both 
real  and  personal  property  they  need  be  filed  only  once  and  are 
in  all  respects  considered  as  mortgages  upon  realty  only.  The 
mortgage  itself  will  provide  that:  "Any  personal  property  or 
chattels  above  conveyed  and  transferred,  or  intended  so  to  be, 
now  held  or  hereafter  acquired,  shall  be  deemed  real  estate  for 
all  the  purposes  of  this  indenture,  and  shall  be  held  and  taken 
to  be  fixtures  and  appurtenances  of  the  said  railroad  and  part 
thereof,  and  are  to  be  used,  and  in  the  case  of  a  sale  thereof 
are  to  be  sold  therewith  and  in  the  same  manner  and  not 
separate  therefrom,  except  as  herein  otherwise  provided." 

The  mortgage  may  be  a  lien  upon  both  tangible  and  in- 
tangible property.  Part  of  the  intangible  property  of  every 
corporation  consists  of  certain  rights  and  franchises,  the  pos- 


l66  FUNDED    DEBT 

session  of  which  is  essential  to  the  operation  of  its  business. 
These  rights  and  franchises  should  always  be  subjected  to  the 
lien  of  a  mortgage  covering  the  whole  property  of  the  corpora- 
tion or  any  separately  operated  part  thereof.  This  follows 
from  the  very  nature  of  the  protection  intended  to  be  afforded 
the  bondholders.  Upon  default  the  bondholders  can  either  seek 
to  have  the  mortgaged  properties  sold  or  may  take  possession 
of  and  operate  them.  They  must,  therefore,  be  able  to  vest  in 
purchaser  or  to  acquire  for  themselves  the  rights  and  fran- 
chises under  which  the  operations  are  required  to  be  conducted. 
These  rights  and  privileges  are  the  property  of  the  corporation 
and,  unless  alienated  by  the  provisions  of  the  mortgage  con- 
currently with  the  other  properties,  they  remain  vested  in  the 
corporation.  All  mortgages  include  provisions  extending  the 
lien  to  "all  and  singly  the  franchises,  rights,  and  privileges  now 
or  hereafter  appurtenant  to  or  used  in  connection  with  the  lines 
of  railway  above  mentioned,  or  any  branch  thereof."  Or, 
more  specifically,  to  "all  corporate,  municipal,  and  other  fran- 
chises, rights,  easements,  or  immunities  now  owned  or  which 
may  hereafter  be  owned,  held,  or  enjoyed  by  or  in  any  manner 
conferred  upon  said  company." 

These  franchises  do  not  include  the  right  to  be  a  corpora- 
tion, which  right  is  the  property  of  the  members  of  the  cor- 
poration ;  hence,  although  all  of  the  property  of  the  corporation 
may  be  taken  from  it  under  foreclosure  of  the  mortgage,  it  will 
continue  in  existence  as  a  corporation. 

Other  intangibles  may  be  specifically  subjected  to  the  mort- 
gage, such  as  "all  licenses,  patents,  patent  rights,  and  franchises 
now  owned  or  used,  or  which  may  hereafter  be  owned  or  used, 
by  said  company." 

The  income  of  a  company  is  not  included  in  the  mortgaged 
properties  unless  it  is  specifically  declared  to  be  so  included. 
Sometimes  the  income  is  pledged  to  secure  interest  alone,  as  in 
the  case  of  income  bonds. 

Mortgage  May  Cover  Property  Acquired  Later.     The 


BONDS,   TRUST   DEEDS,   AND    MORTGAGES  167 

mortgage  may  and  usually  does  cover  both  property  owned  by 
the  corporation  at  the  time  when  the  mortgage  is  executed  and 
that  which  may  thereafter  be  acquired.  As  already  noted,  a 
mortgage  is  theoretically  a  conveyance  of  property,  the  imme- 
diate and  present  use  and  possession  of  w^hich  are  reserved  by 
the  mortgagor.  A  conveyance  cannot  usually  pass  legal  title 
to  property  which  the  grantor  does  not  own  but  which  he  may 
subsequently  acquire,  so  that  "in  the  case  of  an  individual,  a 
general  charge  on  all  the  property  which  he  may  subsequently 
acquire  might  well  enough  be  held  contrary  to  public  policy 
and  void,  being  in  the  nature  of  a  mortgage  of  the  person  and 
reducing  the  individual  to  a  state  of  virtual  villeinage"  ;*  but 
these  considerations  do  not  apply  to  corporations  and  it  is  now 
well  established  that  conveyances  by  way  of  mortgage  of  after 
acquired  property  are  effective  in  equity.  Any  other  conclu- 
sion would  substantially  defeat  the  utility  of  a  trust  mortgage, 
since  a  lien  securing  an  issue  of  millions  of  dollars  in  bonds 
would  be  practically  worthless  if  it  covered  only  property  be- 
longing to  the  company  at  the  time  of  its  creation,  especially 
where  the  mortgage  has  been  executed,  as  it  so  often  is,  im- 
mediately upon  the  incorporation  of  the  company  when  it  owns 
little  or  no  property.  The  after-acquired  property  clause  may, 
on  the  other  hand,  prove  embarrassing  to  future  financing  for 
additional  construction  or  new  acquisitions  of  property,  since 
it  may  cause  the  mortgage  lien  to  attach  without  furnishing 
the  means  of  acquiring  the  necessary  capital.  Where  this  con- 
dition obtains,  it  may  become  necessary  to  defeat  or  defer  the 
lien  of  the  mortgage  by  placing  title  of  the  additional  property 
in  a  separate  but  controlled  corporation,  and  then  leasing  the 
property  from  that  company,  or  else  to  acquire  title  subject  to 
prior  liens. 

§  91.     Security  Value  of  Property  Mortgaged 

So  far  as  it  serves  to  secure  pecuniary  obligations,  there  is 

*  Machen  on  Corporations,  Vol.  2,  page  1856. 


l68  FUNDED   DEBT 

a  very  marked  distinction  between  the  basis  of  a  mortgage 
executed  by  an  individual  or  a  corporation  engaged  in  a  purely 
private  enterprise,  and  that  executed  by  a  public  service  cor- 
poration. 

Where  mortgages  are  given  to  secure  money  lent  to  an  in- 
dividual or  to  a  purely  private  corporation,  the  amount  of  the 
money  lent  bears  some  relation  to  the  value  of  the  property 
mortgaged.  The  lender  of  money  looks  to  the  value  of  the 
security  offered  and  lends  a  greater  or  less  proportion  of  that 
value  according  to  the  extent  of  the  risk  he  is  willing  to 
assume;  he  does  not,  however,  assume  any  of  the  risk  of  the 
enterprise  of  the  borrower.  He  expects  that  whatever  the 
fortune  of  the  borrower  may  be,  his  claim  will  be  protected 
by  the  mortgage,  and  should  the  borrower  be  unable  to  pay 
back  the  money  at  the  time  appointed,  he  will,  by  causing  a  sale 
of  the  property  upon  which  his  claim  is  made  a  lien,  be  able 
to  have  the  same  satisfied.  This  supposes  a  market  in  which 
the  property  subjected  to  the  lien  of  the  mortgage  has  a  value 
independent  of  the  enterprise  of  the  owner  and  where  it  will 
find  a  ready  sale. 

The  holder  of  bonds  in  a  public  service  corporation,  how- 
ever, does  not  occupy  a  corresponding  position  of  security 
because  there  are  no  open  markets  for  the  properties  and  no 
fixed  values,  and  also  because  he  is  restricted  by  public  policy 
in  the  exercise  of  his  remedies.  The  greater  part  of  the  prop- 
erties covered  by  a  mortgage  may  consist  of  tracks  of  a  rail- 
road or  of  a  street  railroad,  the  conductor  system  of  an  elec- 
tric company  or  a  telephone  company,  the  pipe  line  of  a  gas 
or  water  company,  and  other  machinery  and  equipment 
peculiarly  adapted  to  the  operations  of  those  companies  and 
having  but  a  nominal  value  for  any  other  purpose.  Apart 
from  the  operations,  and  considered  as  rails  and  ties,  copper 
or  iron  wire,  poles  and  fixtures,  wrought  iron  or  other  pipe, 
machinery,  and  real  estate,  the  value  of  these  properties  is 
almost  negligible.     Very  little  of  the  right-of-way  of  rail- 


BONDS,    TRUST    DEEDS,   AND    MORTGAGES  169 

roads  could  be  sold  to  neighboring  farmers  even  at  a  nominal 
price,  while  an  electric  railroad  will  either  not  have  any,  or  at 
best  have  but  little  right-of-way  which  it  can  resell,  especially 
if  operating  wholly  within  city  limits.  Lands  occupied  by  rail- 
road stations  and  shops  represent  but  a  small  part  of  their 
total  investment.  The  rails,  ties,  pipes,  etc.,  to  say  nothing  of 
the  machinery,  would  have  but  junk  value,  and  often  the  cost 
of  tearing  them  up  or  taking  them  down  would  not  be  covered 
by  the  salvage.  Yet  these  properties  could  not  be  duplicated 
at  an  amount  less  or  perhaps  even  equal  to  the  total  par  value 
of  the  bonds  they  are  mortgaged  to  secure. 

There  is  no  market  in  which  such  properties  have  any 
values  assigned  them.  If  offered  for  sale,  the  only  way  of 
realizing  an  amount  even  remotely  approximating  the  original 
cost  is  to  find  purchasers  who  will  continue  the  use  of  those 
properties  in  the  operations  to  which  they  are  adapted,  so  that 
the  only  substantial  element  of  value  adhering  to  those  prop- 
erties is  the  commercial  success  of  the  enterprise. 

Suppose  that  the  operation  of  a  certain  property  in  a  given 
locality  has  demonstrated  that  such  operations  are  not  and 
cannot  be  made  commercially  successful;  such,  for  instance, 
as  a  railroad  built  to  carry  ore  from  certain  mines  which  have 
become  exhausted,  leaving  the  railroad  without  any  traffic  or 
the  possibility  of  developing  traffic.  The  operation  of  such  a 
road  will  be  promptly  discontinued.  If  it  is  then  sold  to 
satisfy  the  claims  of  bondholders,  the  sale  will  have  but  little, 
if  any,  effect  in  reducing  their  loss,  which  will  be  almost  as 
great  as  though  their  claims  had  not  been  secur.ed  at  all.  In- 
deed, had  their  claims  been  unsecured  their  loss  might  not  have 
been  as  great,  because  they  would  have  demanded  and  re- 
ceived a  higher  rate  of  interest  to  represent  not  only  a  fair 
return  on  the  investment  but  an  additional  payment  as  well  to 
discount  the  eventuality  of  loss. 

On  the  other  hand,  if  the  operations  of  a  company  have 
proved    a    success    commercially,    the    bondholder    is    amply 


170  FUNDED   DEBT 

secured  even  if  the  original  cost  of  the  property  was  much 
less  than  the  amount  of  bonds  issued  against  it;  for  if  the 
corporation  through  adverse  circumstances  goes  into  default, 
necessitating  a  sale  of  the  properties,  there  will  be  others 
anxious  to  secure  the  property  for  a  substantial  consideration, 
or  it  may  be  to  the  advantage  of  the  bondholders  themselves 
to  take  over  and  operate  the  property. 

Public  policy  demands  that  the  operation  of  enterprises 
upon  which  the  public  is  dependent  shall  not  be  discontinued. 
Railroads  must  continue  to  run,  communities  must  continue 
to  be  supplied  facilities  for  lighting,  heating,  communication, 
transportation,  etc.,  hence  courts  have  been  reluctant  to  decree 
foreclosures  of  such  enterprises  for  the  satisfaction  of  debts 
unless  there  is  reasonable  assurance  that  they  will  pass  into 
the  control  of  those  who  will  continue  their  uninterrupted  and 
efficient  operation.  This  policy  not  only  restricts  the  market 
but  limits  the  exercise  of  the  remedies  to  which  the  bondholder 
is  theoretically  and  under  the  strict  terms  of  the  mortgage 
entitled.  This  matter  is  further  discussed  in  connection  with 
foreclosures  and  reorganizations  (see  §§  96,  97). 

Because  of  the  misconception  that  often  arises  as  to  the 
security  of  bond  issues  under  a  mortgage,  some  have  recom- 
mended the  English  debenture  bond  as  more  correctly  and 
clearly  reflecting  the  nature  of  the  security.  These  bonds  are 
usually  secured  on  the  "undertaking,"  meaning  the  whole 
enterprise,  the  entire  business  of  the  company,  so  that  the 
bondholder  is  put  upon  notice  that  he  must  look  to  the  success 
of  the  enterprise  for  the  assurance  of  his  claim. 

§  92.     Control,  Actual  and  Contingent,  of  Bondholders 

The  essence  of  the  bondholder's  security  is  the  continuance 
of  operations  sufficiently  profitable  to  assure  the  regular  pay- 
ment of  interest.  It  is  to  his  advantage,  therefore,  to  reinforce 
the  lien  upon  the  property  by  some  measure  of  control  over 
the  corporate  affairs  and  operations.     Seldom  are  bondholders 


BONDS,   TRUST    DEEDS,   AND    MORTGAGES  171 

granted  direct  or  positive  control  over  corporate  affairs — that 
is  the  prerogative  of  the  stockholders.  They  possess,  never- 
theless, a  certain  measure  of  control,  the  greater  part  of  which 
is  indirect,  contingent,  or  negative — control  by  veto  rather 
than  command,  as  it  were.  The  provisions  of  a  mortgage, 
and  the  relation  of  the  mortgaged  property  to  other  properties 
owned  and  operated  by  the  debtor  corporation,  need  to  be  very 
carefully  examined  in  estimating  the  strength  of  the  security 
offered. 

For  instance,  where  bonds  are  a  first  and  direct  liera  upon 
the  entire  property  of  the  company,  or  upon  any  distinct  por- 
tion thereof  which  can  be  operated  independently  of  the  other 
portions,  the  chief  security  lies  in  the  fact  that  upon  default 
the  bondholders  would  come  into  absolute  control  of  the  prop- 
erty. Bondholders  always  have  this  contingent  control  which 
may,  upon  default  on  the  part  of  the  stockholders,  become 
actual.  Since  such  an  eventuality  will  involve  considerable 
loss  to  stockholders,  they  will  do  their  utmost  to  prevent  it, 
and  the  exercise  of  caution  thus  imposed  upon  them  serves  to 
benefit  the  bondholder  by  providing  a  valuable  check  upon  the 
misuse  of  revenues  or  extravagance  in  operation.  On  the 
other  hand,  when  it  becomes  evident  that  operations  will  be 
unprofitable,  the  stockholders  may  seek  to  protect  themselves 
against  impending  loss,  and  will  be  anxious  to  remain  in  con- 
trol as  long  as  it  is  possible  to  get  anything  out  of  the  prop- 
erty. In  the  attempt  they  may  sacrifice  the  future  efficiency 
and  value  of  the  plant  by  neglecting  maintenance,  ignoring  re- 
placements, and  curtailing  all  expenses  until  the  property  be- 
comes so  deficient  that  dividends  cannot  possibly  be  main- 
tained. The  bondholders  will  then  discover  that  their  capital 
has  been  exhausted  and  they  have  been  remanded  to  a  lien 
upon  a  worthless  plant. 

There  may  be  provisions  in  the  trust  deed  intended  to 
prevent  such  a  contingency  as  that  described  in  the  foregoing 
paragraph.     It  may  be  provided  that  a  portion  of  earnings 


172 


FUNDED   DEBT 


shall  be  applied  to  the  building  up  of  maintenance  and  de- 
preciation reserves  until  a  predetermined  sum  is  accumulated ; 
or  it  may  be  provided  that  a  certain  proportion  of  the  gross 
earnings  shall  be  spent  or  reserved  each  and  every  year  for 
maintenance  to  be  charged  to  operating  expense  accounts. 
Provisions  of  this  nature  are  perhaps  most  frequent  in 
mortgages  issued  by  reorganized  companies.  Where  efficient 
state  regulation  obtains,  all  public  service  companies  are  sub- 
jected, as  a  matter  of  public  policy,  to  requirements  looking 
to  the  safeguarding  of  the  security  along  the  lines  indicated 
by  the  above  provisions  of  mortgages. 

A  mortgage  may,  and  often  does,  contain  restrictions  upon 
the  stockholders  in  their  dealings  with  the  property  so  as 
further  to  protect  the  bondholders.  A  common  and  effective 
provision  is  one  limiting  the  outstanding  capitalization,  pro- 
viding, for  instance,  that  the  outstanding  debt  shall  not  ex- 
ceed a  specified  multiple  of  the  gross  earnings  for  the  previous 
twelve  months,  or  that  no  more  than  a  certain  proportion  of 
the  total  amount  shall  be  issued  in  each  year.  A  provision 
such  as  the  last  is  irttended  to  assure  the  investors  that  the 
company  will  not,  during  a  given  period,  throw  more  bonds 
on  the  market  than  can  be  advantageously  absorbed.  It  is  an 
attempt  to  uphold  the  market  values  of  bonds  by,  first,  avoid- 
ing the  depreciating  influence  on  market  price  of  a  new  offer 
while  a  former  issue  remains  not  fully  absorbed,  and  second, 
giving  the  corporation  opportunity  to  realize  upon  the  revenue- 
producing  projects  to  which  the  proceeds  of  former  issues 
have  been  applied  so  that  its  credit  may  be  correspondingly 
strengthened  and  subsequent  issues  marketed  to  better  ad- 
vantage. These  provisions,  although  valuable,  are  somewhat 
less  important  than  they  were  before  the  advent  of  state  regu- 
lation, for  where  the  consent  of  a  state  commission  is  requisite 
to  the  issue  of  bonds,  there  is  opportunity  for  full  preliminary 
discussion,  of  all  matters  pertaining  to  the  expediency  of  the 
issue  or  the  protection  of  other  creditors.    It  is  always  well  to 


BONDS,   TRUST    DEEDS,   AND    MORTGAGES  173 

have  the  trust  deed  embody  such  provisions,  however,  for  it 
gives  the  bondholders  a  certain  measure  of  control  independent 
of  governmental  commissions. 

§  93.    Trustees 

In  selecting  trustees  under  corporate  mortgages,  trust 
companies  in  financial  centers  are  favored.  Many  advantages 
are  claimed  in  the  selection  of  these  companies  instead  of  in- 
dividual persons.  "They  do  not  die;  the  large  amount  of 
financial  business  which  they  daily  transact  provides  them 
with  the  machinery  for  such  purposes ;  while  their  well-known 
names  stand  as  evidence  to  the  purchasing  public  that  at  least 
the  necessary  formalities  have  been  complied  with." 

Trustees  do  not  become  guarantors  of  the  bonds  issued 
upon  the  security  of  the  mortgage.  Most  of  the  large  trust 
companies,  however,  recognize  the  fact  that  their  position  and 
influence  impose  upon  them  some  measure  of  responsibility  to 
safeguard  the  interests  of  the  bondholders.  In  addition  to  the 
responsibility  thus  voluntarily  assumed,  a  trustee  becomes 
charged  with  certain  definite  responsibilities  and  becomes 
obligated  to  perform  the  duties  outlined  in  the  mortgage  in- 
denture. He  represents  the  bondholders  and  stands  in  a 
fiduciary  capacity;  he  must,  therefore,  deal  with  them  in 
absolute  good  faith  and  he  cannot  have  any  interest  in  the 
property  or  in  the  debtor  corporation  which  may  even  slightly 
conflict  with  the  administration  of  the  trust.  When  the  acts 
of  the  trustee  imperil  the  safety  of  the  property  under  his 
control,  and  his  continuance  in  ofiice  may  prejudice  the  rights 
of  the  holder,  he  may  be  restrained  by  injunction  and  even 
removed  by  the  court.  The  mortgage  itself  usually  will  pro- 
vide a  method  for  the  removal  of  the  trustee  and  the  substitu- 
tion of  a  successor. 

It  would  not  be  altogether  correct  to  characterize  the 
trustee  as  an  agent  of  the  bondholders  generally,  for  in  certain 
instances  he  really  occupies  an  independent  position.     In  still 


174 


FUNDED  DEBT 


other  instances  his  duties  to  both  the  corporation  and  its  bond- 
holders are  coextensive ;  in  some  actions  he  is  really  the  agent 
of  the  bondholders  alone.  In  at  least  one  situation  he  becomes 
an  agent  for  the  corporation  itself,  that  is,  where  he  is  the 
custodian  of  securities  pledged  as  collateral  by  the  corporation. 
Should  any  of  the  companies  whose  securities  are  held  by  him 
be  in  default,  he  will  be  called  upon  by  the  pledgor  corpora- 
tion to  institute  the  proceedings  necessary  for  enforcing  the 
mortgage  or  trust  by  which  the  pledged  securities  defaulted 
upon  are  secured. 

In  all  litigation  connected  with  the  trust  the  trustee  repre- 
sents the  bondholders.  Bondholders  can  exercise  their  rights 
against  the  property  only  through  the  trustee,  except  in  ex- 
traordinary cases  where  the  trustee  may  refuse  to  institute  the 
proper  proceedings  and  a  bondholder  may  take  it  upon  himself 
to  do  so.  If  the  trustee  acts  in  good  faith,  whatever  binds  him 
in  litigation  instituted  or  other  proceedings  had  under  the  deed 
of  trust,  binds  the  bondholders  as  well. 

Mortgage  provisions  limiting  the  liability  of  the  trustee 
for  negligence  in  the  administration  of  the  trust  are  general, 
excusing  him  from  taking  any  action  unless  indemnified 
against  loss,  etc.  Just  how  extensively  these  provisions  may 
absolve  the  trustee  from  responsibility  is  not  altogether  clear. 
It  has  been  held  that  a  stipulation  exempting  the  trustee  from 
any  liability  except  for  his  own  wilful  and  intentional  breaches 
of  trust  excuses  him  from  any  responsibilitv  for  mere  mis- 
takes or  misconception  of  his  obligations.  Trust  companies 
designated  as  trustees  are  ordinarily  very  conscientious  in  the 
exercise  of  their  obligations  and  not  much  litigation  has  re- 
sulted because  of  their  malfeasance  or  misfeasance. 

A  trustee  is  bound  to  see  to  it  that  the  mortgage  is  duly 
recorded,  and  if  he  should  neglect  to  do  so  and  a  subsequent 
encumbrance  should  obtain  priority,  he  may  be  held  liable  to 
the  bondholders  for  the  resulting  loss.  He  should  be  par- 
ticularly diligent  in  the  protection  and  enforcement  of  the 


BONDS,   TRUST    DEEDS,   AND    MORTGAGES  175 

security;  for  instance,  where  any  large  quantity  of  property 
is  later  to  be  acquired  and  brought  within  the  lien  of  the 
mortgage,  he  should  require  satisfactory  proof  that  those 
properties  are  not  subject  to  encumbrances  ranking  prior  to 
the  lien  of  the  mortgage. 

Until  the  debtor  corporation  defaults,  the  duties  of  the 
trustee  are  mainly  passive;  but  after  default  they  become 
active,  and  he  must  take  definite  and  appropriate  action.  His 
duties  in  this  contingency  are  described  in  connection  with 
the  discussion  of  bondholders'  remedies  (see  §  96). 

§  94.     Certification  of  Bonds  by  Trustee 

One  of  the  most  important  duties  imposed  upon  the  trustee 
is  that  of  certifying  bonds  for  issue.  Under  practically  all 
mortgages  no  bonds  can  be  issued  without  the  indorsement 
of  the  trustee  upon  each  bond,  certifying  that  the  prescribed 
conditions  of  issue  have  been  met.  The  exercise  of  this  power, 
if  not  perfunctorily  used,  enables  him  to  safeguard  the  in- 
terests of  the  bondholders  through  insistence  upon  strict  per- 
formance of  all  the  acts  required  by  the  mortgage  to  be  per- 
formed as  conditions  precedent  to  the  sale  of  the  bonds.  If 
the  corporation  could  issue  bonds  without  any  restriction,  or 
demand  certification  without  adequately  accounting  for  former 
issues,  the  mortgage  might  afford  but  little  security.  Since 
the  conditions  under  which  certification  must  be  given  are  pre- 
scribed by  the  express  provisions  of  the  mortgage,  trust  com- 
panies which  realize  the  responsibility  of  this  function  should 
demand  that  mortgages  be  so  drawn  as  to  place  within  their 
possession  suitable  data  by  w^hich  they  may,  before  certifica- 
tion of  additional  bonds,  satisfy  themselves  and  the  bond- 
holders that  the  proceeds  of  previous  issues  have  been  legiti- 
mately applied  to  the  purposes  for  which  the  money  was  ad- 
vanced. 

Adequate  provisions  for  insuring  the  proper  use  of  the  pro- 
ceeds of  issues  already  placed  are  very  essential.     Take,  for 


176 


FUNDED   DEBT 


instance,  the  situation  of  a  company  projecting  the  construc- 
tion of  a  railroad  and  issuing  bonds  for  the  financing  of  the 
project.  The  bondholders  do  not  have  any  considerable 
tangible  security  until  the  road  is  completely  built  and 
equipped.  In  the  meantime,  the  sole  assurance  that  they  may 
have  for  the  integrity  of  their  investment  is  that  the  proceeds 
of  the  bonds  issued  have  been  properly  expended  in  construc- 
tion and  for  capital  projects.  Requirements  for  certification 
purport  to  extend  this  assurance  to  the  bondholder,  but 
whether  they  do  so  or  not  as  a  matter  of  fact  will  depend 
upon  the  conditions  under  which  certification  may  be  de- 
manded of  the  trustee. 

Merely  limiting  the  amount  to  be  issued  during  a  given 
period  may  benefit  the  bondholders  in  other  respects,  but  not 
very  materially  so  far  as  the  assurance  that  the  proceeds  of 
past  issues  have  been  properly  expended  is  concerned. 
Affirmative  proof  of  these  facts  should  also  be  placed  on 
record  with  the  trustee,  and  the  mere  recital  in  the  mortgage 
that  the  company  will  not  spend  the  proceeds  for  other  than 
proper  purposes,  is  not  very  effective.  Such  a  provision  as 
the  following,  for  instance,  makes  a  certification  a  purely  per- 
functory act;  " dollars  of  the  face  value  of  said  bonds 

shall  be  certified  and  delivered  to  the  Railroad  Company,  or 
upon  its  order,  on  filing  zvith  the  Trustees  from  time  to  time  a 
copy  of  a  resolution  of  the  Board  of  Directors  of  the  Rail- 
road Company,  certified  under  its  corporate  seal  by  its  Secre- 
tary or  an  Assistant  Secretary,  requesting  such  delivery.  The 
Railroad  Company  covenants  that  none  of  such  bonds  or  the 
proceeds  thereof  shall  be  used  for  the  ordinary  maintenance 
of  the  lines  of  railroad,  ferries,  and  other  property  owned  or 
controlled  by  the  Railroad  Company,  or  for  any  other  ex- 
penditures which  are  ordinarily  treated  by  railroad  corpora- 
tions as  operating  expenses." 

Effective  assurance  is  extended  to  bondholders  by  pro- 
visions,  for  instance,  that  after  the   first  instalment  of   an 


BONDS,    TRUST    DEEDS,   AND    MORTGAGES  177 

authorized  issue  has  been  delivered  to  the  company,  no  more 
bonds  shall  be  certified  by  the  trustee  except  upon  satisfactory 
proof  that  the  proceeds  of  bonds  theretofore  certified  "have 
been  actually  used,  or  actually  appropriated  and  set  aside  for 
liability  actually  incurred"  for  the  purposes  originally  con- 
templated, specifying  the  amounts  applied  to  each  one  of  those 
purposes.  It  is  also  provided  that  "the  price  paid  or  liability 
incurred  for  such  construction,  or  for  such  acquisition,  better- 
ments, or  improvements  shall  not  be  in  excess  of  the  fair  value 
of  such  property  or  of  such  work,  and  that  the  bonds  included 
in  such  certificate  v^^ere  sold,  disposed  of,  or  otherwise  ac- 
counted for,  at  not  less  than  their  fair  market  value  at  the 
time  of  such  sale,  disposition,  or  accounting,"  together  with 
other  facts  to  show  that  the  amounts  enumerated  contain  no 
duplication  of  expenditures  or  liability  included  in  any  pre- 
vious certification.  Provisions  as  detailed  as  these  impose  a 
great  degree  of  responsibility  and  work  upon  the  trustee. 

In  a  number  of  instances  mortgages  have  provided  that 
certificates  of  bonds  shall  be  limited  to  a  certain  amount  per 
mile.  If  the  estimates  of  total  cost  have  been  carefully  made 
and  the  amount  of  bonds  fixed  per  mile  is  substantially  below 
the  total  estimate,  such  provisions  will  practically  amount  to 
requirements  that  the  remainder  of  the  cost  be  paid  out  of 
the  proceeds  of  stock  issues  or  moneys  from  other  sources, 
thus  maintaining  a  margin  of  safety  for  the  bondholder. 

The  trustee  is  not  usually  called  upon  to  investigate  the 
accuracy  of  reports  made  to  him.  His  responsibility  is  limited 
to  the  certification  of  bonds  in  accordance  with  the  provisions 
of  the  mortgage  and  which  prescribe  that  "a  certificate  signed 
by  the  President  or  Vice-President  of  the  Railroad  Company, 
or  by  its  Treasurer,  as  to  any  fact,  matters,  or  conclusions 
appurtenant  to  the  right  to  certify  and  deliver  bonds,  as  afore- 
said, shall,  as  regards  the  trustee,  be  conclusive  evidence  of 
such  facts,  matters,  and  conclusions  and  be  full  authority  for 
the  action  of  the  Trustee  in  accordance  therewith." 


178  FUNDED    DEBT 

Where  adequate  public  regulation  prevails,  the  state  com- 
mission, in  authorizing  the  issue  of  securities,  will  specify  the 
purposes  to  which  the  proceeds  of  the  issue  shall  be  applied, 
and  it  should  prescribe  such  conditions  and  restrictions  as  will 
insure  full  compliance  with  the  terms  of  its  authorization. 
Otherwise,  there  might  be  presented  to  some  a  strong  tempta- 
tion, after  having  secured  authority  for  the  issue  of  securities 
sufficient  to  meet  the  cost  of  high  grade  construction,  to 
cheapen  the  work  so  that  a  portion  of  the  proceeds  of  the 
authorized  issue  might  be  made  available  for  purposes  not 
contemplated  by  the  commission.  Hence  the  New  York 
(Second  District)  Public  Service  Commission  in  authorizing 
an  electric  railroad  corporation  to  issue  bonds  "for  the  acquisi- 
tion of  property  in  the  construction  of  its  proposed  double 
track  railroad  ....  and  for  the  construction  and  completion 
of  the  said  road  and  maintenance  of  service  thereon,  in  accord- 
ance with  the  plans  and  specifications  therefor  submitted  upon 
the  application  for  this  authorization,"  etc.,  specified:  "The 
said  bonds  shall  be  issued  from  time  to  time  in  instalments  of 
not  more  than  $1,000,000  each,  and  only  upon  the  making  and 
entry  of  an  order  subsequent  and  additional  hereto  authoriz- 
ing such  issue,  upon  proof  ....  upon  each  application  show- 
ing for  what  purposes  the  proceeds  of  said  bonds  are  to  be 
used  in  the  construction  and  completion  of  the  work  for  which 
they  are  hereby  authorized  and  the  disposition  made  of  the 
proceeds  of  previous  issues  of  stocks  and  bonds;  ....  nor 
shall  such  bonds  be  authorized  except  upon  such  application  it 
is  shown  that  the  work  is  progressing  in  conformity  with  the 
plans  and  specifications  submitted  by  the  company  upon  this 
application." 

§  95.     Custody  of  Stocks  and  Bonds  Pledged  as  Collateral 

When  the  purpose  of  a  bond  issue  is  the  purchase  of  the 
capital  stock  or  bonds  of  other  corporations,  the  trust  deed 
will  authorize  an  amount  of  bonds  necessary  for  the  purpose 


BONDS,    TRUST    DEEDS,   AND    MORTGAGES  179 

to  be  certified  upon  the  presentation  to  the  trustee  of  the 
securities  acquired.  In  such  case  the  securities  acquired  be- 
come subject  to  the  provisions  of  the  deed  and  must  be  de- 
livered to  the  trustee  pursuant  to  the  laws  governing  the  mak- 
ing of  a  pledge. 

It  goes  without  saying  that  since  the  bonds  issued  impose 
a  fixed  charge  for  interest,  the  stocks  or  bonds  acquired  out 
of  the  proceeds  should  be  such  as  will  reimburse  the  purchas- 
ing corporation  for  the  amount  of  the  interest  which  it  will 
have  to  pay.  The  reimbursement  may  be  by  direct  interest  or 
dividend  payments  but  most  often  the  acquisition  of  the  stocks 
and  bonds  of  another  company  is  for  the  purpose  of  exer- 
cising control  over  that  company  to  the  end  that  its  properties 
or  operations  may  be  made  to  contribute  definitely  to  the  suc- 
cess of  the  controlling  company's  operations.  For  instance, 
the  railroad  of  the  controlled  corporation  may  be  so  operated 
as  to  assure  its  development  and  continuance  as  a  feeder  to 
the  railroad  of  the  controlling  corporation.  The  considera- 
tions which  should  control  the  acquisition  of  stocks  and  bonds 
out  of  the  proceeds  of  bond  issues  are  discussed  in  succeeding 
chapters. 

If  securities  of  other  corporations  are  pledged  under  a 
mortgage,  the  trustee  may  do  whatever  is  necessary  to  secure 
the  title  of  those  securities,  i.e.,  he  may  have  the  shares  of 
stock  transferred  to  his  name  as  trustee,  or  he  may  have 
coupon  bonds  converted  into  registered  and  the  registered 
bonds  recorded  in  his  name.  He  may  also  be  called  upon  to 
take  proper  proceedings  to  maintain  the  integrity  of  those 
securities,  and,  if  necessary,  to  exercise  the  majority  control 
of  the  shares  held  by  him  to  cause  the  renewing  or  extension 
of  the  corporate  existence  of  companies  whose  charters  are 
about  to  expire. 

The  exercise  of  voting  rights  and  the  disposition  of  in- 
come from  the  deposited  securities  are  provided  for  in  the 
trust  deed,  the  usual  arrangement  being  that,  prior  to  default. 


l8o  FUNDED    DEBT 

the  pledgor  corporation  may  vote  the  stock  and  receive  divi- 
dends and  interest  accruing  from  the  deposited  securities. 
After  default,  the  trustee  will  exercise  voting  rights  upon  the 
stock  and  receive  the  interest  and  dividends  upon  the  deposited 
securities.  In  some  few  cases  the  arrangement  is  that  the 
trustee  shall  collect  the  interest  or  dividends,  and  apply  the 
necessary  amount  to  the  payment  of  interest  upon  the  col- 
lateral bonds,  and  the  remainder  to  a  sinking  fund. 

Upon  default  on  the  part  of  the  pledgor,  the  trustee  fore- 
closes the  equity  of  the  pledgor  and  may  then  realize  upon 
the  deposited  securities  in  accordance  with  the  decree  of  fore- 
closure. In  lieu  of  instituting  foreclosure  proceedings,  he  may 
exercise  remedies  authorized  in  the  trust  deed  and  which  per- 
mit him,  among  other  remedies,  to  sell  the  securities  upon  the 
open  market. 

§  96.    Enforcement  of  Lien  for  the  Satisfaction  of  Debt 

Upon  default  of  the  debtor  corporation  in  respect  of  any 
obligation  upon  the  bond  or  any  requirement  of  the  mortgage, 
the  right  of  the  bondholders  to  exercise  their  claim  against 
the  property  becomes  actual. 

The  rights  and  remedies  of  the  bondholders  may  be  en- 
forced immediately  upon  default  in  the  payment  of  principal 
or  of  any  instalment  of  principal,  or  of  interest.  They  may 
also  be  enforced  upon  the  commission  or  the  omission  of  some 
act  which  violates  a  covenant  of  the  mortgage,  provided,  how- 
ever, that  the  mortgage  does  not  contain  stipulations  post- 
poning the  time  when,  after  default,  the  remedies  may  be  exer- 
cised. It  is  customary  to  provide  that  these  rights  and 
remedies  shall  become  active  only  if  default  in  the  payment  of 
interest,  or  in  the  due  performance  or  observance  of  any 
covenant  or  condition  of  the  mortgage,  shall  have  continued 
for  six  months  after  the  payment  fell  due,  or  after  written 
notice  from  the  trustee,  or  a  specified  proportion  of  the  bond- 
holders, concerning  the  default  in  performance  of  mortgage 


BONDS,   TRUST   DEEDS,   AND    MORTGAGES  jgi 

requirements.  These  provisions  are  designed  to  protect  the 
corporation  from  any  unfair  advantage  being  taken  of  its 
mistakes,  inadvertences,  or  temporary  financial  embarrass- 
ment. No  period  of  grace  is  allowed  for  the  payment  of  the 
principal  or  any  instalment  thereof. 

The  rights  and  remedies  of  bondholders  are  enforced,  as 
already  noted,  by  and  through  the  trustee,  who  is  the 
mortgagee.  The  method  of  procedure  is  sometimes  left  to  his 
sole  discretion,  but  more  frequently  the  mortgage  contains 
elaborate  provisions  concerning  the  right  of  bondholders  to 
direct  the  action  of  the  trustee,  describing  the  proportion  of 
bondholders  who  must  unite  in  the  demand  upon  the  trustee, 
providing  for  indemnities  to  be  tendered  him,  etc.  If  the 
trustee  refuses  to  act  in  a  proper  case,  any  bondholder  may 
proceed  to  enforce  the  rights  and  remedies  provided  by  the 
mortgage  or  by  general  law,  on  behalf  of  himself  and  the 
other  bondholders. 

The  mortgage  provides  two  methods  of  proceeding  against 
the  property.  First,  the  trustee  may  take  possession  of  the 
mortgaged  property  and  operate  it  until  the  money  due  has 
been  paid  or  adequately  provided  for,  and  if  necessary,  he 
may  sell  the  property  and  satisfy  the  claims  out  of  the  pro- 
ceeds. Second,  he  may  sell  the  mortgaged  property  at  public 
auction  without  entering  into  possession  or  operating  it.  A 
mortgagee  cannot  exercise  either  of  these  remedies  as  a  matter 
of  right  unless  the  mortgage  gives  the  power.  These  remedies 
are  seldom  exercised  because  of  the  personal  liabilities  which 
would  be  incurred  by  the  trustee  in  the  course  thereof. 

The  third  remedy  given  to  the  mortgagee  does  not  depend 
upon  any  provision  of  the  mortgage  but  is  a  right  exercised 
under  the  law  of  the  realm.  This  is  the  remedy  of  fore- 
closure. Upon  default,  the  mortgagee  may  apply  to  the  court 
for  a  foreclosure  of  the  mortgage.  The  court  then  ta.kes 
jurisdiction  over  the  mortgaged  property  and  all  the  rights 
and  claims  of  all  parties  in  or  to  that  property.     It  will  take 


l82  FUNDED   DEBT 

actual  possession  of  the  property  through  the  appointment 
of  a  receiver  and  do  all  things  which  are  necessary  to  con- 
serve the  property  pending  adjudication.  In  a  proper  case 
the  court  will  direct  the  receiver  to  continue  the  business  of 
the  defaulting  corporation. 

Trustees  almost  invariably  resort  to  this  remedy  of  fore- 
closure to  escape  the  serious  responsibilities  which  the  exer- 
cise of  either  of  the  other  methods  would  impose  upon  them. 

During  the  foreclosure  proceedings  and  at  any  time  be- 
fore sale,  or  while  the  trustee  is  in  possession  pursuant  to 
the  power  given  him  by  the  mortgage,  the  debtor  corporation 
may  reassume  control  and  possession  of  the  property  by  satis- 
factorily discharging  the  obligations  which  had  been  defaulted 
upon.  In  ordinary  foreclosure  actions  the  mortgagor  is  given 
the  right  to  redeem  the  property  even  after  sale,  but  in  cor- 
porate deeds  of  trust  the  mortgagor  waives  the  protection  of 
such  laws. 

The  receiver  acts  for  the  court  and  incurs  no  personal 
liability  in  the  course  of  the  proper  discharge  of  his  duties, 
for  he  is  then  acting  in  an  official  capacity  as  the  representa- 
tive of  the  court.  His  situation  differs  widely  from  that  of 
the  trustee  who  takes  possession  under  the  provisions  of  the 
mortgage. 

The  decree  of  foreclosure  states  the  amount  found  by  the 
court  to  be  due  under  the  mortgage  and  orders  the  debtor  to 
pay  the  sum  within  a  specified  period;  at  the  same  time  it 
directs  the  sale  of  the  property  in  case  the  debtor  fails  to  make 
the  payment  as  directed.  The  manner  of  sale,  the  time  and 
place,  etc.,  are  set  forth  in  the  order.  The  court  may  direct 
the  sale  of  the  property  in  one  parcel  or  in  different  parcels, 
with  due  consideration  to  the  mortgage  provisions  and  the 
nature  of  the  property.  It  is  quite  usual  for  railroad 
mortgages  to  stipulate  that  the  properties  shall  be  sold  as  one 
parcel.  The  decree  also  directs  the  manner  in  which  the  pro- 
ceeds of  the  sale  shall  be  distributed.     After  the  sale  the  final 


BONDS,    TRUST    DEEDS,   AND    MORTGAGES  183 

decree  is  signed  by  the  court,  thus  confirming  all  that  has  been 
done  under  its  jurisdiction. 

§  97.     Reorganization 

Since  public  policy  demands  that  the  operation  of  rail- 
roads and  other  public  utilities  be  constantly  maintained,  the 
courts  hesitate  to  order  foreclosure  where  it  is  apparent  that 
strict  enforcement  of  the  mortgagee's  remedies  will  endanger 
the  public  service.  They  have,  therefore,  encouraged  every 
legitimate  means  which  will  assure  the  passage  of  control  to 
those  who  will  maintain  that  service.  Not  only  is  this  a  matter 
of  interest  to  the  public,  but  those  who  are  seeking  to  enforce 
the  claim  are  themselves  vitally  interested  in  finding  a  pur- 
chaser who  will  take  over  the  properties  with  the  intention  of 
keeping  them  in  the  service  in  which  they  have  already  been 
placed.  If  such  a  purchaser  cannot  be  found,  the  bondholders 
will  get  a  very  small  part  of  the  amount  necessary  to  satisfy 
their  claims,  for  the  bulk  of  public  utility  properties  will  have 
only  junk  value  when  withdrawn  from  the  service  for  which 
designed. 

Thus  the  enforcement  of  the  bondholders'  claim  against 
the  property  has  come  to  represent,  in  most  cases,  corporate 
reorganization.  The  foreclosure  may  be  decreed  and  the  prop- 
erty sold,  but  all  plans  for  the  purchase  of  the  property  on  be- 
half of  those  who  have  agreed  to  enter  the  reorganization  will 
have  been  fully  arranged  for  and  ways  and  means  provided. 
A  substantial  proportion  of  the  bondholders  acting  together 
will  cause  the  appointment  of  a  committee  and,  by  depositing 
their  bonds  with  the  committee  or  its  designated  depositary, 
will  delegate  authority  to  it  in  the  formulation  of  a  reorgani- 
zation plan  and  its  enforcement.  The  property  is  then  pur- 
chased on  their  behalf  at  the  foreclosure  sale,  and  reincorpora- 
tion effected  pursuant  to  the  statutes  (generally  the  same  in  all 
states)  authorizing  the  purchasers  at  such  sale  to  reorganize 
as  a  new  corporation.     The  new  corporation  will  start  out 


l84  FUNDED    DEBT 

with  a  clean  page  and  can  enter  upon  such  financing  as  is 
necessary  to  put  the  properties  in  operating  condition  and  to 
launch  the  new  enterprise.  The  property  may,  of  course,  have 
been  sold  subject  to  encumbrances,  which  the  new  corpora- 
tion will  be  required  to  assume,  but  the  equities  which  were 
cut  off  by  the  foreclosure  and  the  burdens  of  which  the  prop- 
erty was  freed  may  be  large  enough  to  allow  new  financing  to 
a  sufficient  extent. 

In  many  instances  there  are  a  multiplicity  of  equities  and 
priorities  of  claim  under  many  mortgages,  each  covering  some 
essential  part  of  the  property.  Manifestly,  to  order  a  fore- 
closure and  sale  on  each  mortgage  separately  would  disrupt  the 
railroad  or  utility  to  a  hopeless  extent;  moreover,  the  legal 
proceedings  might  be  so  long-drawn-out  as  to  exhaust  all  rea- 
sonable patience  and  to  necessitate  inordinate  expense.  Hence, 
reorganization  is  quite  frequently  a  compromise  between  many 
groups  of  creditors;  it  is  not  unusual  to  include  the  stock- 
holders as  well.  The  bondholders  in  the  old  corporation  are 
permitted  to  exchange  their  holdings  for  stock  or  bonds  of  the 
reorganized  company,  at  par  or  in  some  other  proportion, 
and  either  with  or  without  some  further  payment  in  cash.  The 
basis  of  exchange  may  be  different  for  the  several  classes  of 
bondholders,  depending  upon  the  original  priorities  of  their 
claims  or  the  relative  importance  of  the  property  constituting 
the  security. 


CHAPTER   IX 
CLASSIFICATION    OF    BONDS 

§  98.     Bond  Characteristics 

The  function  of  a  bond  title  is  to  express  the  saUent  char- 
acteristics of  the  bond  to  which  it  relates;  a  classification  of 
bonds,  therefore,  consists  very  largely  of  definitions  of  titles 
which  are  currently  used.  To  attempt  a  logical  classification 
of  existing  bond  issues  is  almost  impossible.  There  are  a  num- 
ber of  issues  which  are  called  what  they  are  not  and  were  never 
intended  to  be.  There  are  others  so  ingeniously  designated 
that  the  name  might  express  any  one  of  a  number  of  charac- 
teristics some  of  which  the  bonds  may  possess  in  part  and 
some  of  which  they  may  not  possess  at  all.  The  classification 
of  bonds  which  is  attempted  here  is  along  general,  broad 
lines.  The  purpose  of  the  discussion  is  to  bring  out  the  distinct 
characteristics  of  bond  issues  and  not  to  enumerate  all  existing 
bond  titles. 

Secured  and  Unsecured  Bonds.  The  primary  classifica- 
tion is  that  between  secured  and  unsecured  bonds.  Secured 
bonds  include  all  those  issues  which  are  supported  by  a  lien 
on  the  property  of  the  debtor,  no  matter  how  remote  or  con- 
tingent that  lien  may  be. 

Indication  of  Property  Mortgaged.  Secured  bonds  are 
classified  into  two  main  groups  on  the  basis  of  the  nature  of 
the  property  mortgaged  or  pledged  for  their  security;  the  first 
group  includes  all  those  which  are  secured  by  a  lien  on  realty, 
and  the  second  those  secured  by  a  lien  on  personalty.  Sub- 
classifications  of  these  two  groups  indicate  more  specifically 
the  kind  of  property  mortgaged  or  pledged ;  for  instance,  bonds 
secured  on  realty  may  be  designated  as  divisional,  extension, 

185 


l86  FUNDED   DEBT 

terminal  bonds,  etc.,  while  bonds  secured  on  personalty  may 
be  collateral  bonds  or  equipment  obligations. 

Indication  of  Ranking  Order  of  Liens.  The  order  of 
mortgages  imposing  liens  upon  the  property  for  the  securing 
of  bond  issues  is  always  indicated  in  the  bond  title,  e.g.,  first 
mortgage,  prior  lien,  refunding  mortgage,  etc.  The  last  title, 
however,  and  others  similar  to  it,  such  as  general  mortgage  and 
cotisolidated  mortgage,  suggest  rather  than  specifically  indicate 
a  ranking  order;  they  give  notice  of  underlying  issues  and 
prior  liens  which  in  time  will  be  satisfied  and  discharged. 
These  titles,  in  fact,  indicate  the  purpose  of  issue  much  more 
than  they  indicate  the  ranking  order  of  liens. 

Indication  of  Purpose.  The  indication  of  the  purpose  for 
which  bonds  are  issued  is  often  expressed  in  bond  titles,  but 
since  in  many  instances  the  purpose  is  the  acquisition  of  a 
certain  kind  of  property  which  will  be  subjected  to  the 
mortgage  of  the  bonds,  the  title  serves  a  dual  purpose,  to  wit, 
that  of  expressing  theltpurpose  and  also  of  indicating  the  prop- 
erty comprising  the  security.  Instances  of  this  kind  of  bonds 
are  purchased-line  bonds,  bridge  bonds,  etc.  Other  cases 
where  a  purpose  is  expressed  along  with  other  characteristics 
of  the  issue  are  those  of  refunding  bonds,  general  mortgage 
botids,  etc.,  above  referred  to.  Improvement  bonds  also  come 
within  this  class. 

Indication  of  Terms  or  Method  of  Payment.  In  the  mat- 
ter of  the  specified  term  in  years,  bonds  are  classified  as  long- 
or  short-term,  and  also  as  straight  bonds  or  serial  bonds. 
Straight  bonds  are  those  where  the  entire  issue  matures  at  the 
end  of  a  given  number  of  years.  Serial  bonds  are  those  which 
mature  in  series  during  a  period  of  years.  These  character- 
istics are  not  expressed  in  terms  in  the  bond  title,  but  the  term 
in  years  is  expressed,  and  if  they  mature  in  series,  that  fact 
is  usually  indicated.  Then,  as  to  options  concerning  earlier 
payment,  there  are  redeemable,  callable,  and  optional  bonds; 
convertible  bonds  also  come  within  this  class,  expressing  an 


CLASSIFICATION    OF   BONDS  187 

option  on  the  part  of  the  bondholder.  Again,  as  to  the 
mediums  in  which  repayment  is  to  be  made,  bonds  are  de- 
scribed as  gold  bonds,  legal  tender  bonds,  etc. 

Reinforced  Security.  In  relation  to  additional  security, 
there  are  two  important  groups,  i.e.,  sinking  fund  bonds  and 
guaranteed  bonds.  Sinking  fund  bonds  are  those  secured  by 
a  mortgage,  one  of  the  provisions  of  which  is  that  the  equity 
of  the  bondholders  will  be  increased  by  the  creation  and  main- 
tenance of  a  sinking  fund.  Guaranteed  bonds  express  rein- 
forcement of  the  security  by  the  assurance  of  a  third  party 
that  the  debt  will  be  satisfied  according  to  its  terms. 

§  99.     Mortgage  Bonds  Secured  on  Realty 

The  term  "real  estate  mortgage"  when  forming  part  of  a 
bond  title  simply  indicates  that  real  estate  comprises  the  prop- 
erty mortgaged  for  the  securing  of  the  bonds,  which  is  true  of 
the  principal  issues  of  all  public  service  corporations,  although 
personalty  is  also  included.  If  the  term  were  to  stand  alone, 
it  would  express  no  very  definite  meaning  concerning  the  char- 
acteristics of  the  bond,  although  it  would  be  a  very  proper 
and  complete  title  for  bonds  issued  by  real  estate  companies. 
There  may  be  exceptional  bond  issues  of  public  service  cor- 
porations which  also  may  be  properly  entitled  real  estate 
mortgage  bonds,  or  real  estate  bonds — a  synonymous  term,  but 
one  which  is  often  thought  to  suggest  a  more  definite  limitation 
of  the  property  to  realty  alone. 

Note,  for  instance,  the  funding  and  real  estate  gold  ^Vz  per 
cents  of  1950  of  the  Western  Union  Telegraph  Company, 
secured  by  a  first  lien  on  all  the  company's  real  estate  in  the 
cities  of  New  York  and  Chicago,  together  with  all  buildings, 
fixtures,  and  equipment  thereon.  Bonds  of  railroad  com- 
panies secured  by  lien  on  non-carrier  properties  are  fre- 
quently described  as  "real  estate  bonds,"  although  the  title 
carries  no  suggestion  of  the  distinction  between  these  proper- 
ties and  others  owned  by  the  company.     Land-grant  bonds 


l88  FUNDED   DEBT 

are  really  real  estate  bonds,  secured  by  a  mortgage  on  lands 
granted  by  the  government  and  intended  for  sale  to  settlers, 
the  proceeds  constituting  a  fund  to  redeem  the  bonds. 

"Mortgage  bond"  as  part  of  a  title  sufficiently  expresses 
the  fact  that  the  security  consists  of  a  lien  on  realty,  or  realty 
and  personalty  mixed. 

Divisional  bonds  are  secured  by  a  mortgage  on  a  distinct 
operating  branch  or  division  of  a  railroad,  and  issued  either 
by  the  present  debtor  corporation  or  by  a  predecessor  com- 
pany. Extension  bonds  represent  issues  made  for  the  purpose 
of  constructing  an  extension  of  existing  main  or  branch  lines 
where  the  part  newly  built  will  not  constitute  a  distinct  oper- 
ating division.  Purchascd-line  bonds  (not  purchase  money) 
represent  issues  for  the  purchase  of  a  road  already  con- 
structed. Terminal  bonds  which  are  the  direct  obligations  of 
railroad  companies  themselves  are  secured  by  lien  upon  ter- 
minal properties.  More  often  "terminal  bonds"  are  the  obli- 
gations of  terminal  companies  organized  in  the  interest  of, 
and  to  be  controlled  by,  a  number  of  railroad  corporations 
which  will  also  guarantee  the  bonds.  Terminal  bonds  include 
tracks  and  other  railroad  equipment  in  addition  to  lands  and 
buildings;  such  inclusion  does  not  affect  the  description  of 
the  bonds  except  that  if  the  tracks  are  of  any  considerable 
length  the  bonds  which  are  the  obligations  of  a  railroad  com- 
pany may  be  better  described  by  "divisional"  or  some  other 
term.  Similar  to  terminal  bonds  are  ferry  bonds,  dock  bonds, 
zvharf  bonds,  bridge  bonds,  etc.  In  all  these  cases  the  title  of 
the  bond  expresses  the  purpose  of  issue  and  also  indicates  the 
property  subjected  to  the  lien  of  the  mortgage.  Improvement 
bonds  also  express  a  purpose  of  issue,  but  do  not  indicate  the 
nature  of  the  properties  upon  which  bonds  will  be  secured. 

§  100.     Mortgage  Bonds  Secured  on  Personalty 

The  two  best-known  types  of  funded  debt  falling  within 
this  class  are  Collateral  bonds  and  Equipment  obligations. 


CLASSIFICATION   OF   BONDS  189 

The  security  consists  wholly  of  personalty,  although  in  the 
case  of  collateral  bonds  there  may  be  superimposed,  by  the 
nature  of  the  collateral,  the  security  of  a  real  estate  mortgage. 

I.  Collateral  Bonds.  These  are  funded  debt  obligations 
secured  by  a  pledge  of  securities  owned  by  the  pledgor.  These 
securities  may  be  those  (a)  of  corporations  subsidiary  to  and 
controlled  by  the  pledgor,  (b)  of  corporations  wholly  inde- 
pendent of  the  pledgor,  or  (c)  of  the  pledgor  itself. 

In  by  far  the  greater  number  of  instances  the  collateral 
consists  of  securities  of  subsidiary  companies.  These  sub- 
sidiary companies  are  of  two  classes,  those  which  once  were 
independent  of  the  present  controlling  company,  and  those 
which  were  organized  with  the  specific  purpose  of  being  made 
such  subsidiaries.  The  manner  in  which  these  relationships 
are  created  and  the  method  of  financing  the  purchase  of  securi- 
ties are  described  in  Chapter  XVIII. 

Stock  ownership  is  a  necessary  requisite  of  control  over 
another  corporation,  hence  shares  of  stock  are  used  most 
often  as  collateral.  The  bonds  of  subsidiary  corporations  are 
not  ordinarily  held  for  the  purposes  of  control.  There  are 
some  rare  instances  where  it  is  desirable  to  reinforce  the  con- 
trol derived  from  ownership  of  capital  stock  by  a  direct  lien 
on  the  subsidiary  company's  property,  but  where  bonds  are 
pledged  as  collateral  the  fact  most  often  is  that  the  controlling 
corporation  could  issue  its  own  bonds  to  better  advantage 
than  the  bonds  of  the  subsidiary.  Suppose  A  corporation  or- 
ganizes B  corporation  for  the  purpose  of  building  an  extension 
into  an  adjoining  state;  if  bankers  will  take  $5,000,000  thirty- 
year  bonds  of  B  corporation  at  only  85  per  cent  of  par,  but 
are  willing  to  take  the  bonds  of  A  corporation  at  90,  A  cor- 
poration, by  issuing  its  own  bonds  and  pledging  the  bonds  of 
B  as  collateral  to  its  own  issue,  will  save  $8,334  annually. 
Suppose  that  the  bankers  had  also  required  the  bonds  of  B 
corporation  to  bear  5  per  cent  interest  while  they  were  willing 
to  take  the  bonds  of  A  corporation  at  45-'2  per  cent,  the  latter 


190 


FUNDED   DEBT 


by  issuing  its  own  bonds  will  save  annually  an  additional 
$25,000  in  rentals  to  be  paid  or  other  deductions  to  be  made 
from  its  income.  The  bonds  of  the  subsidiary  corporation 
thus  pledged  would  be  first  mortgage  bonds,  that  is,  a  first 
lien  upon  the  road  constructed  by  it,  so  that  although  the  col- 
lateral bonds  of  A  corporation  represent  only  a  pledge  of 
securities,  by  virtue  of  the  mortgage  incidence  of  the  collateral 
they  are  an  indirect  but  nevertheless  effective  first  mortgage 
lien  on  the  road  of  the  subsidiary  corporation.  Such  issues  are 
sometimes  designated  as  collateral  mortgage  bonds. 

Where  the  collateral  consists  of  the  securities  of  controlled 
or  system  corporations,  the  measure  of  safety  can  seldom  be 
predicated  upon  the  value  of  the  collateral.  The  most  important 
element  of  that  security  really  lies  in  the  credit  and  the  repu- 
tation for  good  management  of  the  company  which  issues  the 
collateral  bonds,  for  the  reason  that  the  same  conditions  which 
may  affect  the  situation  of  the  major  corporation  adversely 
are  apt  to  affect  the  situation  of  the  controlled  corporation  in 
like  manner.  Moreover,  the  management  of  the  major  cor- 
poration, if  in  actual  operating  control  of  the  subsidiary,  may 
so  manipulate  the  accounts  of  the  subsidiary  as  to  maintain  the 
apparent  integrity  of  its  own  operations  at  the  expense  of  the 
other. 

The  most  noteworthy  instance  of  pledging  the  securities 
of  an  independent  company  under  a  collateral  trust  is  that 
furnished  by  the  collateral  trust  distribution  gold  bonds,  so 
called,  of  the  Adams  Express  Company,  issued  as  special  divi- 
dends in  1898  and  1907.  In  some  respects  the  title  collateral 
trust  bonds  seems  inapplicable  to  these  securities  for  the  secur- 
ing of  which  the  company  has  placed  certain  stocks  and  bonds 
of  independent  companies  with  the  trustee.  According  to  the 
company's  statement,  these  securities  are  not  mortgaged  or 
pledged  "but  were  transferred  outright  to  the  Trustee  of  said 
Collateral  Trust  Bonds.  The  respondent  (Adams  Express 
Company)  has  no  equity  of  redemption";  moreover,  the  inter- 


CLASSIFICATION    OF   BONDS 


191 


est  at  4  per  cent  is  not  paid  by  the  company  "but  by  the  Trustee 
out  of  the  income  of  the  securities  which  were  transferred  by 
trust  deeds."  ^ 

In  ordinary  cases,  where  securities  of  independent  corpora- 
tions are  pledged,  the  coHateral  trust  bonds  are  for  short  terms 
only,  issued  to  meet  a  pressing  money  stringency — collateral 
trust  notes,  more  properly  so  called.  They  are  issued  most 
often  where  a  company  needs  temporary  capital  which  it  does 
not  want  to  obtain  from  an  issue  of  long-term  bonds  or  from 
the  sale  of  securities  owned  by  it  and  which  would  probably 
suffer  depreciation  through  forced  sale,  hence  it  borrows  on 
short-term  notes  secured  by  collateral. 

Naturally,  it  is  not  good  policy  for  a  corporation  to  pledge 
the  specific  securities  of  independent  corporations,  held  for  in- 
vestment, under  a  mortgage  covering  a  long  period,  thus 
estopping  itself  from  the  realization  of  profits  in  a  rising 
market  or  of  protecting  itself  from  losses  in  a  falling  market, 
unless  the  right  of  substitution  is  expressly  reserved,  as  it 
usually  is.  Where  such  right  has  been  reserved,  the  pledgor 
may  withdraw  from  the  pledge  any  securities  by  substituting 
others  of  like  value.  The  collateral  trust  distribution  gold 
bonds  of  the  Adams  Express  Company  provide  for  substitu- 
tion. Issues  where  this  right  of  substitution  is  reserved  are 
sometimes  designated  convertible  collateral  trust  bonds  (to  be 
distinguished  from  collateral  trust  convertible  bonds). 

It  is  quite  usual  for  a  corporation  to  borrow  money  from 
a  bank  for  temporary  purposes  and  to  deposit  its  own  treasury 
bonds  as  collateral  for  the  loan,  and  it  is  not  unusual  for  a 
corporation  even  to  issue  collateral  bonds  or  notes  secured  by 
the  deposit  or  pledge  of  another  issue  of  its  own  mortgage  or 
other  bonds.  An  expedient  of  this  nature  is  resorted  to  where 
the  need  of  capital  is  temporary  so  that  it  is  better  to  avoid 
the  issue  of  long-term  securities,  or  it  may  be  resorted  to  be- 


'  Quotations  from  company's  annual  report  to  Public  Service  Commission,  Second 
District,  New  York. 


1^2  FUNDED    DEBT 

cause  of  the  uncertain  condition  of  the  bond  market  where 
long-term  bonds  could  not  be  sold  readily  without  being  sub- 
jected to  heavy  discounts. 

2.  Equipment  Obligations.  There  is  a  class  of  funded 
debt,  most  common  among  railroad  corporations  but  not  un- 
known to  other  public  utilities,  generally  termed  "equipment 
obligations"  because  issued  to  raise  capital  to  be  applied  to 
the  purchase  of  equipment  and  secured  by  a  lien  on  the  equip- 
ment so  purchased.  Within  this  general  term  of  "equipment 
obligations"  are  included  equipment  bonds,  car  or  equipment 
trust  certificates,  and  car  or  equipment  trust  bonds.  The  cir- 
cumstances under  which  equipment  obligations  were  first  in- 
troduced have  clothed  this  form  of  funded  debt  with  a  number 
of  special  characteristics,  and  are  responsible  for  the  form  in 
which  these  obligations  are  issued. 

In  the  early  history  of  railroad  finance  long-term  bonds 
were  issued  for  the  original  construction,  including  the  equip- 
ment. Equipment,  however,  depreciates  much  faster  than  the 
way  and  structures.  As  the  equipment  originally  installed  wore 
out,  its  replacement  became  necessary  either  from  funds  on 
hand,  current  earnings,  or  the  proceeds  of  a  new  loan.  Since  no 
adequate  amount  had  been  withheld  out  of  past  earnings,  be- 
cause of  defective  administrative  or  accounting  practice,  and 
since  the  current  earnings  were  insufficient,  the  necessary  sums 
had  to  be  borrowed.  In  addition  to  the  replacement  of  equip- 
ment already  mortgaged,  increasing  traffic  and  territorial  ex- 
pansion created  new  demands  which  had  to  be  met  and  for 
which  very  inadequate  provision  had  been  made  in  the  initial 
financing.  There  were  practical  difficulties  in  the  way  of 
borrowing  more  money  either  under  the  existing  mortgages 
(which  had  covered  the  equipment  requiring  replacement)  or 
under  a  separate  mortgage.  Out  of  the  position  in  which  the 
railroads  thus  found  themselves,  there  was  evolved  a  new 
method  which  served  a  twofold  purpose — it  enabled  the  com- 
panies to  acquire  rolling  stock  out  of  the  proceeds  of  a  new 


CLASSIFICATION    OF   BONDS 


193 


loan  made  under  conditions  which  deferred  the  lien  of  existing 
mortgages,  thus  permitting  a  first  lien  to  be  imposed  upon  the 
equipment  to  secure  the  new  issue  of  bonds;  at  the  same 
time,  in  view  of  the  experience  gained  from  the  issue  of  long- 
term  obligations  covering  short-lived  property,  it  strengthened 
the  security  for  the  new  loan  by  requiring  compliance  more 
or  less  automatically  with  the  essentials  of  sound  financial 
practice  relating  to  moneys  borrowed  on  such  security,  which 
is,  that  where  rapidly  depreciating  property  is  subject  to  the 
lien  of  a  mortgage,  provision  for  the  immediate  or  future  re- 
tirement of  a  proportionate  amount  of  the  debt  should  be 
made  concurrently  with  the  exhaustion  of  the  property 
mortgaged.  This  purpose  may  be  effected  by  making  the 
bonds  redeemable  serially  or  by  providing  a  sinking  fund. 
The  former  is  the  usual  method  adopted  in  connection  with 
equipment  obligations. 

Serial  maturities  of  equipment  obligations  are  so  arranged 
that  the  debt  is  discharged  before  the  usefulness  of  the  equip- 
ment ceases.  There  is  thus  a  substantial  and  constantly  in- 
creasing equity  in  the  holder  of  the  obligations  still  outstand- 
ing, through  the  gradual  reduction  of  the  debt  following  the 
initial  payment  which  at  the  very  outset  represents  an  equity  of 
from  10  to  25  per  cent  of  the  cost. 

It  might  be  said  that  through  serial  repayments  the  equip- 
ment pays  for  itself.  This  would  be  true  if  each  maturing 
series  were  paid  by  the  debtor  corporation  out  of  current 
earnings,  the  amount  of  the  payment  being  charged  to  the 
income-deduction  accounts.  There  is  no  impropriety,  how- 
ever, in  applying  to  the  payment  of  these  maturities  moneys 
derived  from  sources  other  than  the  current  earnings;  except 
that  the  proceeds  of  bonds  which  are  secured  by  the  mortgage 
the  lien  of  which  was  to  be  deferred  through  the  issue  of 
the  equipment  obligations,  should  not  be  used  for  the  pay- 
ment of  the  maturing  series. 

(a)  Equipment  Bonds.     These  bonds  represent  direct  in- 


194 


FUNDED   DEBT 


debtedness  of  a  railroad  or  other  public  service  corporation, 
incurred  for  the  purchase  of  equipment  which  has  been  specific- 
ally subjected  to  a  first  lien  to  secure  the  bonds.  To  impose 
a  first  lien  upon  the  equipment  it  is  necessary  to  use  some  de- 
vice which  will  effectively  defer  the  attachment  of  the  lien  of 
existing  mortgages. 

This  transaction  very  often  takes  the  form  of  a  conditional 
sale,  i.e.,  the  property  is  sold  upon  condition  that  the  vendor 
shall  retain  the  title  until  the  property  is  fully  paid  for.  A 
conditional  sale  is  very  similar  in  its  nature  to  a  chattel 
mortgage,  but  with  this  important  distinction,  that  in  a  chattel 
mortgage  the  mortgagor  must  first  acquire  title  to  the  chattel 
before  he  can  subject  it  to  a  mortgage,  while  in  a  conditional 
sale  the  vendee  does  not  acquire  title  at  all  until  the  payments 
are  complete.  It  is  because  of  this  characteristic  that  the  de- 
vice of  a  conditional  sale  is  of  such  great  utility  in  equipment 
obligations.  The  issuers  of  such  obligations  usually  have  out- 
standing general  mortgages,  the  lien  of  which  would  attach  to 
newly  acquired  property  the  instant  title  passes  to  the  vendee, 
in  this  case  the  obligor  under  the  general  mortgage.  Through 
the  device  of  a  conditional  sale  the  lien  of  the  general 
mortgage  does  not  attach  to  the  equipment  since  the  title 
thereto  has  not  passed  to  the  railroad  company,  so  that  the 
latter  is  free  to  incur  new  obligations  for  the  securing  of 
which  it  can  pledge  the  equipment  acquired. 

Conditional  sales  have  not  always  been  favored  in  law; 
for  a  long  time,  in  fact,  they  rested  under  the  avowed  con- 
demnation of  the  law  as  defeating  the  claims  of  existing  credi- 
tors. In  Pennsylvania  conditional  sales  are  still  regarded  with 
disfavor  by  the  law,  but  practically  every  other  state  has 
recognized  them  by  statute. 

Under  equipment  bonds,  title  to  the  equipment  purchased 
with  the  proceeds  is  transferred  to  a  trustee,  who  leases  it  to 
the  operating  corporation,  the  latter  paying  as  rental  under 
the  lease  an  amount  equalling  the  interest  on  the  outstanding 


CLASSIFICATION   OF   BONDS  igg 

bonds  in  addition  to  a  sum  sufficient  to  take  up  the  maturing 
bonds  of  the  series.  As  a  matter  of  fact  these  payments  are 
made  direct  to  the  bondholder,  either  by  the  corporation  itself 
or  through  its  fiscal  agents,  although  very  often  the  fiscal 
agent  is  the  same  person  as  the  trustee.  When  the  bonds  are  all 
retired,  the  trustee  transfers  title  to  the  operating  corporation. 

(b)  Car  or  Equipment  Trust  Certificates.  Car  trust  certifi- 
cates represent  the  original  form  of  equipment  obligations, 
arising  out  of  the  disfavor  with  which  conditional  sales  were 
regarded  and  the  difficulties  which  surrounded  the  execution  of 
chattel  mortgages,  to  wit,  the  requirement  that  such  a  mortgage 
should  be  recorded  in  every  county  where  the  property  was 
held.  As  rolling  stock  is  carried  almost  everywhere,  the  diffi- 
culty and  cost  of  recording  chattel  mortgages  made  them 
wholly  impracticable. 

Car  trust  certificates  do  not  represent  the  direct  obligation 
of  a  railroad  or  other  public  service  corporation,  but  rather  an 
interest,  much  like  that  of  a  share  of  stock,  in  an  unincorpor- 
ated association  which  owns  certain  equipment  purchased 
with  the  proceeds  of  the  certificates  and  subject  to  a  contract 
of  resale  to  a  railroad  or  other  public  service  corporation. 
Possession  and  use  of  the  equipment  is  transferred  to  the  rail- 
road company  under  a  lease,  by  the  terms  of  which  the  latter 
covenants  to  pay  an  annual  rental  of  an  amount  ecjual  to  the 
interest  or  dividends  upon  the  certificates  of  the  association,  as 
well  as  a  specified  proportion  of  the  principal  of  the  whole 
fund  represented  by  the  certificates ;  these  sums  are  applied  by 
the  association  to  the  retirement  of  the  serially  maturing  cer- 
tificates. The  lease  and  title  are  then  assigned  to  a  trustee 
for  the  securing  of  the  certificate  holders.  The  lease  thus 
assigned  represents  the  immediate  security  for  the  certificates, 
but  since  it  is  provided  that  in  default  of  payment  or  failure  to 
perform  any  condition  of  the  agreement  the  lease  may  be 
terminated  and  the  trustee,  as  assignee,  repossess  himself  of  the 
equipment,  the  real  security  consists  of  the  equipment  itself. 


ig6  FUNDED    DEBT 

The  certificates  recite  that  the  holder  is  "entitled  to  one 

share  of  $i.ooo  in  the Railroad  Equipment  Trust, 

Series  2,"  and  that  dividends  will  be  paid  upon  the  certificates 
"as  evidenced  by  the  dividend  warrants  attached  thereto." 
These  dividend  warrants  are  in  form  of  bond  coupons  read- 
ing:    "Due  to  the  bearer $22.50,.  being  semiannual 

■Jvidend  on  certificate  No payable  only  out  of  rentals 

under  the  lease  referred  to  in  the  said  certificate."  The  cer- 
tificate itself  and  the  dividend  warrants  are  usually  guaranteed 
by  the  railroad  company.  Originally  the  lease  was  supple- 
mented by  lease  warrants  which,  under  the  guise  of  rental, 
actually  represented  the  deferred  payments  of  the  interest. 
The  lease  warrants  now  are  not  generally  used,  the  provisions 
of  the  lease  agreement  being  considered  sufficient. 

(c)  Car  or  Equipment  Trust  Bonds.  Instead  of  certificates 
of  participation,  corresponding  to  stock,  being  issued  by  an 
association  such  as  above  described,  certificates  of  indebted- 
ness, or  car  trust  bonds,  may  be  issued.  The  basis  of  car  trust 
bonds  is  substantially  that  of  car  trust  certificates,  but  an  addi- 
tional step  is  introduced  through  a  mortgage  on  the  lease. 

(d)  Enforcing  the  Lien  of  Equipment  Obligations.  The 
provisions  for  securing  the  holders  of  equipment  obligations 
are  practically  the  same  whether  these  obligations  take  the 
form  of  equipment  bonds,  car  trust  certificates,  or  car  trust 
bonds. 

The  equipment  must  be  kept  in  good  order  and  repair  and 
is  to  be  numbered  and  marked  for  identification,  bearing 
the  names  of  the  parties  in  interest,  e.g.,  "Guaranty  Trust 
Company  of  New  York,  owner  and  lessor;  Buffalo,  Rochester 
and  Pittsburgh  Railroad  Company,  lessee.  Equipment  Trust 
Series  F."  The  cars  may,  of  course,  bear  the  name  of  the 
railroad  company  which  operates  them. 

An  annual  inventory  is  to  be  furnished  showing  "the  num- 
bers and  description  of  such  as  may  have  been  destroyed  and 
substituted  by  others,  the  numbers  of  those  repaired  during 


CLASSIFICATION   OF   BONDS  ig; 

the  preceding  year,  the  numbers  of  those  at  the  day  of  such 
statement  undergoing  repair  or  in  the  shops  for  repair,"  and 
the  railroad  must  allow  inspection  at  its  own  expense  at  least 
once  a  year. 

Should  possession  be  taken  upon  default,  the  trustee  "may 
either  hold  or  lease  or  dispose  of  said  railroad  equipment  or  so 
much  thereof  as  it  may  be  necessary,  in  such  manner,  at  public 
or  private  sale,  for  cash  or  upon  credit,  and  as  the  trustee  may 
deem  most  beneficial,"  and  if  the  proceeds  be  insufficient,  the 
deficiency  may  be  recovered  from  the  railroad  company. 

Since  the  railroad  company  expressly  undertakes  to  main- 
tain the  number  and  condition  of  the  equipment  subject  to  the 
trust,  it  must  make  adequate  provision  for  depreciation  and 
for  renewals  and  replacements  of  the  property.  For  instance, 
if  a  car  subject  to  the  lien  of  the  ecjuipment  obligations  is  de- 
stroyed, the  obligation  of  the  railroad  company  to  replace  that 
car  is  absolute,  and  it  must  be  replaced  free  from  any  lien 
superior  to  that  of  the  trust  agreement  under  which  the  de- 
stroyed equipment  rested.  It  is  therefore  more  than  desirable 
that  the  company  should  carry  upon  its  books  separate  de- 
preciation, replacement,  and  renewal  accounts  for  this  class  of 
property.  These  accounts  must  be  separately  stated  in  all 
published  reports. 

Equipment  represents  the  tools  with  which  a  railroad  con- 
ducts its  operations;  foreclosure  of  liens,  therefore,  will  be 
most  carefully  avoided.  Consequently,  payments  on  equip- 
ment obligations  will  often  be  promptly  met  even  when  other 
obligations  of  the  company  are  in  default.  A  compilation 
made  by  the  Guaranty  Trust  Company  and  published  under 
the  title  "Railway  Equipment  Obligations"  contains  a  study  of 
the  history  of  various  equipment  obligations.  It  reviews  the 
record  of  railway  companies  reorganized  between  1888  and 
19 14,  or  in  receivership  on  the  date  of  publication,  where  these 
companies  had  outstanding  equipment  obligations.  It  shows 
that  in  almost  every  case  principal  and  interest  of  equipment 


igS  FUNDED    DEBT 

obligations  were  paid  in  full  or  else  the  holders  were  offered 
an  advantageous  exchange  of  securities,  while  other  securities, 
with  a  few  exceptions,  were  reduced  in  rate  or  amount  or 
both.  The  conclusion  of  the  compilers  is  that  ''in  practically 
every  case  of  railway  reorganizations  the  principal  and  in- 
terest of  equipment  obligations  have  been  paid  in  full  or  the 
holders  otherwise  reimbursed  without  loss." 

§  loi.     Ranking  Order  of  Liens 

The  ranking  order  of  the  lien  of  the  mortgage  is  of  the 
very  essence  of  security.  There  may  be  a  number  of 
mortgages  upon  the  same  property,  and  the  determination  of 
their  proper  order  according  to  the  priority  of  lien  may  be- 
come very  difficult.  Often  bond  titles  are  amplified  to  suggest 
this  order  clearly,  but  sometimes  it  happens  that  these  titles 
convey  very  different  meanings  to  those  who  framed  them 
than  they  do  to  others,  the  ambiguity  of  meaning  being  not 
always  disingenuous.  "Railroad  debt  construction  is  a  mys- 
terious and  wonderful  thing — much  more  wonderful  than 
creditable.  The  precedence  of  bond  issues  is  as  delicate,  de- 
batable, and  involved  as  precedence  at  a  state  dinner."  ^  This 
statement  is  equally  true  of  the  debts  of  other  classes  of  cor- 
porations. Careful  examination  is  always  necessary.  As  an 
illustration  of  the  inconsistencies  encountered  may  be  cited  the 
prior  lien  bonds,  so  called,  of  a  certain  railroad  corporation 
which,  according  to  the  generally  accepted  significance  of  the 
terms,  should  impose  a  lien  superior  to  those  of  first  and  other 
mortgages.  As  a  matter  of  fact,  they  are  subject  to  the 
priority  of  first,  second,  third,  fourth,  and  fifth  mortgages  on 
the  greater  part  of  the  road,  and  subject  to  other  mortgages 
on  portions  of  the  road  and  other  property. 

Where  the  bond  title  is  intended  to  indicate  the  ranking 
order  of  the  lien,  certain  terms  more  or  less  definite  should  be 
used.     The  term  first  mortgage  is  self-explanatory;  it  repre- 

'  Lawrence  Chamberlain:     "The   Principles  of  Bond  Investment." 


CLASSIFICATION    OF   BONDS 


199 


sents  the  first  lien  imposed  by  mortgage.  As  relating  to  the 
whole  property  of  the  corporation  whose  bonds  it  secures, 
however,  the  term  is  no  guarantee  of  the  precedence  of  the 
lien,  for  there  may  be  divisional  or  subsidiary  company  liens 
attached  to  various  parts  of  the  line,  each  taking  precedence 
over  the  first  mortgage  placed  upon  the  properties  as  a  whole. 
Where  these  conditions  obtain,  the  first  mortgage  bonds  will 
usually  outlive  the  maturity  of  the  underlying  bonds  so  as  to 
become  eventually  a  first  mortgage  lien  upon  the  entire  prop- 
erty. The  general  character  of  issues  so  related  is  expressed  in 
the  terms  underlying  bonds  as  against  overlying  bonds,  and 
junior  bonds  as  against  senior  bonds.  First  lien  is  synonymous 
with  "first  mortgage,"  but  it  may  properly  indicate  that  it  is 
really  a  first  lien  on  the  property  it  purports  to  cover,  since 
there  are  no  underlying  liens.  The  terms  second  mortgage, 
third  mortgage,  etc.,  suggest  their  own  interpretation  and  are 
in  general  subject  to  rules  similar  to  those  governing  the  ex- 
amination of  first  mortgages.  Obligations  imposing  a  lien 
upon  property  superior  to  those  of  first  or  other  mortgages  are 
called  prior  lien  bonds;  these  are  not  necessarily  secured  by 
mortgage.  Receivers'  certificates  become  prior  lien  bonds  upon 
reorganization  of  the  corporation,  the  priority  arising  out  of 
operation  of  law.  If  prior  lien  bonds  are  secured  by  mortgage 
they  arise  from  contract ;  hence,  the  consent  of  mortgage  bond- 
holders whose  liens  will  become  deferred  thereby  is  neces- 
sarily required. 

The  priority  of  liens  becomes  a  perplexing  matter  and 
places  many  substantial  difiiculties  in  the  way  of  additional 
financing,  where  there  are  a  number  of  outstanding  bond  issues 
of  different  characteristics.  There  is  now  a  decided  preference 
on  the  part  of  financiers  and  bankers  for  large  bond  issues  of 
one  class  in  place  of  many  issues  variously  designated  and 
more  or  less  independent  of  each  other,  relating  to  separate 
parts  of  the  property  of  the  one  corporation,  or  ranking  differ- 
ently as  liens  on  the  same  property.    If  there  is  to  be  only  one 


200  FUNDED    DEBT 

bond  issue,  its  lien  must  necessarily  be  that  of  a  first  mortgage 
on  all  of  the  property  of  the  corporation.  An  old-established 
company,  however,  may  already  have  a  number  of  first 
mortgages  on  separate  parts  of  its  property,  as  well  as  other 
mortgages  of  junior  lien;  even  a  new  corporation  may  be  in  a 
like  situation  by  having  assumed  mortgage  debts  of  purchased 
or  merged  companies.  Manifestly  under  these  circumstances 
the  company  cannot  impose  a  new  first  lien  applying  alike  to 
all  of  its  properties  without  discharging  all  existing  liens,  and 
that  it  may  not  be  able  to  do  until  the  maturity  of  the  bonds. 
It  will,  therefore,  execute  a  general  mortgage  and  will  there- 
after carry  out  all  of  its  loan-capital  financing  through  the 
issue  of  general  mortgage  bonds  which  will  be  put  out  in  series. 
The  lien  of  this  general  mortgage  will  rank  first  on  all  prop- 
erties not  already  encumbered,  and  as  to  other  properties  it 
will  be  a  junior  lien  subject  to  prior  liens.  A  designation 
sometimes  used  is  general  first  mortgage  bonds,  a  term  not 
very  definite  in  meaning,  but  perhaps  intended  to  describe  a 
general  mortgage  which  is  a  first  lien  on  the  major  part  of 
the  company's  property;  in  this  sense  general  and  first 
mortgage  has  been  suggested  as  a  better  term.  First  general 
mortgage,  sometimes  used,  is  altogether  meaningless,  since 
there  can  be  no  second  issue  of  a  general  mortgage.  Blanket 
mortgage  is  an  older  term  of  like  meaning  as,  and  now  super- 
seded by,  general  mortgage. 

General  mortgages  cover  all  property  owned  or  later 
acquired,  and  are  executed  for  amounts  sufficiently  large  to 
meet  all  reasonably  anticipated  demands  for  additional  capital 
or  refunding  operations.  Specific  provisions  for  the  latter 
purpose  are  included  in  the  mortgage,  and  very  often  bonds 
of  the  new  issue  of  a  sufficient  amount  to  redeem  the  under- 
lying bondc  are  placed  in  the  hands  of  the  trustee. 

Consolidated  ynortgage  bonds  are  those  issued  by  a  con- 
solidated corporation  and  secured  by  mortgage  upon  the  prop- 
erties represented  in  Ihc  consolidation.     If  these  properties 


CLASSIFICATION    OF   BONDS  20I 

had  l)ccn  unencumbered  theretofore,  the  new  issue  would  be  a 
consolidated  first  mortgage;  that  situation,  however,  will  very 
seldom  be  found.  Almost  always  the  consolidating  companies 
have  had  bond  issues  of  their  own  outstanding,  and  the 
problem  of  the  consolidated  corporation  is  that  of  putting  out 
a  bond  issue  which  will  produce  additional  funds  and  also 
provide  for  the  refunding  of  the  outstanding  issues;  the  pur- 
pose here  becomes  identical  with  that  of  refunding  or  general 
mortgage  bonds,  and  the  title  may  accordingly  be  consolidated 
refunding  or  cvnsolidatcd  and  general  mortgage  bonds.  Bonds 
secured  by  a  first  lien  on  some  of  the  properties  and  a  deferred 
lien  on  the  others  may  be  described  as  first  and  consolidated 
mortgage. 

Unifying  is  a  term  used  with  much  the  same  meaning  as 
"refunding"  in  bond  titles,  and  expresses  the  eventual  retire- 
ment of  all  existing  issues  and  their  unification  in  one  issue. 

Issues,  the  most  important  purpose  of  which  is  to  merge 
into  one  a  number  of  other  issues  by  either  retiring  them 
forthwith  or  providing  for  their  future  retirement,  are  de- 
scribed as  refunding  bonds.  Naturally,  where  the  refunding 
issue  is  to  supersede  other  liens  it  will  ultimately  become  the 
only  mortgage  lien,  i.e.,  a  first  mortgage,  hence  the  frequent 
combination  of  the  two  terms  in  bond  titles.  First  and  refund- 
ing mortgage  indicates  a  mortgage  which  is  an  immediate  and 
direct  lien  on  only  a  part  of  the  property  mortgaged  and  a 
deferred  lien  on  others.  As  encumbrances  on  the  other  por- 
tions are  removed  through  refunding  operations,  the  mortgage 
will  become  an  immediate  and  direct  lien  on  the  portions 
cleared;  thus 'the  position  of  the  issue  improves  as  each  out- 
standing issue  is  retired.  Refunding  first  mortgage  bonds 
should,  and  ordinarily  will,  relate  to  an  issue  refunding  a  first 
mortgage  issue  and  may  not  imply  at  all  the  purpose  of  con- 
solidating a  number  of  issues;  while  first  refunding  mortgage 
will  relate  to  the  first  mortgage,  in  point  of  time,  executed  to 
secure  bonds  to  be  used  for  refunding  operations. 


202  FUNDED   DEBT 

Bonds  issued  in  full  or  part  payment  of  real  estate  trans- 
ferred to  the  company  are  termed  purchase  money  mortgage 
bonds.  These  may  be  issued  to  the  vendors  of  the  property 
or  to  others  who  are  deemed  to  be  advancing  the  money  for 
the  purchase.  A  purchase  money  mortgage  is  a  prior  lien  upon 
the  property  purchased,  taking  precedence  over  all  other  liens 
which  would  otherwise  attach. 

§  102.     Debts  Unsecured  by  Mortgage  or  Pledge 

Unsecured  debts  are  those  not  reinforced  by  a  lien  upon 
the  property.  The  description  of  "unsecured,"  however,  is  not 
to  be  understood  as  relating  in  any  way  to  the  stability  or 
strength  of  the  debt.  In  the  general  class  of  unsecured  debts 
there  will  be  found  some  of  the  strongest  as  well  as  some  of 
the  weakest  obligations.  The  fact  that  a  loan  has  been  made 
without  security  is  often  evidence  of  unquestioned  credit,  but 
the  circumstances  under  which  it  was  made  need  to  be  known. 

I.  Debentures,  Plain  and  Income  Bonds.  Unsecured 
debts  include  all  the  liabilities  of  the  company  on  open  ac- 
counts, acceptances,  notes,  etc.  The  reference  here,  however, 
is  to  the  more  formally  acknowledged  obligations  and  those 
coming  within  the  term  "funded  debt."  These  are  debentures, 
plain  bonds,  corporation  notes,  and  income  bonds. 

Debentures  is  a  term  very  loosely  used,  relating  to  all  unse- 
cured bond  issues.  The  different  meaning  assigned  to  it 
throughout  England  sometimes  causes  confusion  to  the  reader 
of  financial  literature.  This  different  English  meaning  is  de- 
scribed below.  The  term  plain  bonds  is  now  very  seldom  used. 
Corporation  notes  are  to  be  distinguished  from  ordinary  com- 
mercial paper  in  that  they  represent  a  more  formally  evidenced 
obligation.  The  great  number  of  unsecured  short-term  issues 
which  came  into  general  use  after  the  1907  panic  and  which 
are  still  plentiful,  are  of  this  class. 

All  of  the  above  described  unsecured  bonds  carry  definite 
provisions  as  to  interest  payments,  but  upon  default  the  bond- 


CLASSIFICATION    OF    BONDS  2O3 

holder  has  no  Hen  which  he  can  exercise  and  he  may  recover 
judgment  only  as  any  other  general  creditor  might  do.  Income 
bonds  differ  from  these  issues  in  that  interest  provisions  are 
indefinite;  interest  is  payable  up  to  a  fixed  maximum  rate  only 
if  earned.  They  may  earn  the  fixed  rate,  or  only  a  fraction 
thereof,  or  nothing  at  all.  Their  claim  for  interest  follows 
those  of  other  classes  of  debt.  They  are  a  preferred  claim  on 
earnings  in  precedence  of  that  of  capital  stock.  Income  bonds 
are  sometimes  secured  by  second  mortgage  or  other  junior 
lien,  so  that  the  term  debenture  income  is  sometimes  used  to 
describe  unsecured  issues. 

Unsecured  bonds  are  sometimes  given  contingent  security 
by  agreement  that  the  debtor  corporation  shall  not  place  any 
other  mortgage  upon  its  property,  or  that  if  one  is  placed  the 
debentures  shall  be  included  in,  and  secured  by,  that  mortgage 
equally  and  ratably.  The  equity  existing  at  the  time  the  bonds 
are  issued  and  available  to  the  general  creditors  is  thus  pro- 
tected. 

2.  Meaning  of  "Debenture"  in  the  Financial  Practice  of 
England.  There  is  no  warrant,  in  the  meaning  of  the  word 
itself,  for  the  use  of  "debentures"  as  a  generic  title  to  describe 
all  unsecured  issues;  in  fact  it  can  more  properly  be  applied 
to  all  funded  debt  issues.  This  is  the  sense  in  which  it  is  gen- 
erally used  in  England  where  corporate  debts  are  classified  as 
to  security  into  debenture  bonds,  simple  debentures,  and  mort- 
gage debentures.  It  will  be  worth  while  to  describe  these 
briefly. 

Debenture  bonds  are  unsecured  and  correspond  to  our  plain 
bonds;  they  are  mere  promises  to  pay.  In  the  case  of  simple 
debentures,  to  which  incidental  reference  has  been  made  in 
foregoing  pages,  the  company  charges  its  entire  undertaking 
and  all  its  property  with  the  payment  of  the  amounts  secured 
by  the  debentures.  In  the  event  of  default  upon  the  interest, 
the  principal  matures  and  the  charge  upon  the  undertaking 
becomes  enforcible  through  the  appointment  of  a  receiver. 


204 


FUNDED   DEBT 


The  debenture  holder  may  also  intervene  to  obtain  relief  if  the 
security  is  imperiled,  even  though  the  particular  act  which 
would  make  the  principal  repayable  has  not  yet  occurred.  The 
floating  charge  of  this  class  of  bonds  is  its  chief  characteristic; 
it  leaves  the  company  unembarrassed  and  free  to  deal  with  its 
property  in  the  ordinary  course  of  business  as  if  no  charge 
existed — to  sell,  mortgage,  or  exchange  the  property  as  its 
necessities  may  require.  The  charge  is  dormant  until  by  ex- 
piration of  its  life  or  the  happening  of  an  event  causing  ma- 
turity, the  debenture  becomes  repayable. 

Mortgage  debentures  are  secured  by  a  trust  deed ;  they  cor- 
respond to  our  usual  mortgage  bonds.  Bonds  of  this  class  are 
frequently  issued  where  the  issue  is  of  large  amount ;  beyond 
the  subjection  of  specific  property  to  the  lien  of  the  debt 
(which  may  or  may  not  be  an  added  advantage  over  simple 
debentures),  the  chief  advantage  of  these  bonds  is  to  be  found 
in  the  fact  that  the  agreement  organizes  the  bondholders,  pro- 
vides the  machinery  for  bondholders'  meetings,  and  empowers 
a  majority  of,  say,  two-thirds  or  three-fourths  in  number  and 
value  of  holdings  at  such  meetings  to  bind  the  other  bond- 
holders to  any  promise  or  arrangement  made  by  them  with  the 
corporation. 

Debentures  are  registered  or  to  hearer  (corresponding  to 
coupon  bonds).  In  respect  of  maturity  they  are  terminable  or 
perpetual.  They  may  be  redeemable  or  irredeemable.  These 
characteristics  of  bonds  are  discussed  in  a  succeeding  chapter. 

Debenture  stock  has  the  same  relation  to  borrowed  capital 
as  "stock"  has  to  "shares"  in  English  usage.  (See  §  59.)  It 
represents  the  consolidation  into  one  aggregate  sum  of  all  the 
capital  borrowed  on  each  issue,  and  each  lender,  instead  of 
having  a  number  of  separate  bonds,  is  thereafter  given  one 
certificate  evidencing  the  corporate  debt  for  the  full  amount 
due  him ;  he  may  then  transfer  any  part  of  the  debenture  stock 
in  amounts  of  one  pound  or  multiples  thereof.  The  Commer- 
cial Cable  Company  on  January  i,  1897,  executed  a  mortgage 


CLASSIFICATION    OF   BONDS  20$ 

deed  of  trust  to  the  Farmers  Loan  and  Trust  Company  of  New 
York,  trustee,  securing  an  issue  of  $20,000,000  par  value  of 
500-year  4  per  cent  first  mortgage  bonds,  convertible  at  option 
of  holders  into  "English  Sterling  obligations  to  be  known  as 
debenture  stock" ;  with  like  term  in  years  and  similar  interest 
provisions.  The  principal  and  interest  of  the  stock  were  de- 
scribed as  being  secured  by  the  same  deed  of  trust,  with  like 
remedies  upon  default;  the  trust  deed  further  recited  that  "the 
aggregate  amount  of  said  debenture  stocks  constitutes  and  is 
hereby  declared  to  be  a  funded  debt  of  the  said  Cable  Com- 
pany, duly  acknowledged  to  each  debenture  stockholder  to  the 
extent  of  his  holding." 

3.  Receiver's  Certificates.  These  certificates  are  evi- 
dences of  debt  issued  by  the  authority  of  a  court  and  by  a  re- 
ceiver in  charge  of  the  properties  of  a  corporation.  During 
receivership  they  necessarily  are  prior  claims  against  the  assets 
in  the  receiver's  hands.  If  not  discharged  during  the  receiver- 
ship, they  are  assumed  by  the  company  to  whom  the  receiver 
surrenders  the  property  and  they  become  a  first  lien,  ranking 
ahead  of  first  and  other  mortgage  liens. 

Receiver's  certificates  are  usually  issued  for  short  periods. 
They  are  issued  to  raise  sums  of  money  necessary  for  the  use 
of  the  receiver  in  continuing  operations  and  to  meet  current 
debts,  complete  inconsiderable  portions  of  road  or  plant,  etc. 
From  the  circumstances  attending  the  borrowing  of  money  by 
a  receiver,  at  a  time  when  the  success  of  the  enterprise  itself 
is  in  doubt,  and  the  credit  of  the  corporation  is  nil,  it  becomes 
necessary  to  back  up  with  exceptional  security  the  loans  made 
to  a  receiver,  hence  the  priority  of  lien  attaching  to  these  cer- 
tificates. 

Technically,  receiver's  certificates  are  unsecured,  but  the 
effect  given  to  them  is  such  that  they  become  very  strongly 
secured,  so  far  as  it  is  intended  by  that  term  to  indicate  the 
degree  of  assurance  that  they  will  be  paid  when  due.  They 
usually  meet  with  ready  acceptance. 


2o6  FUNDED   DEBT 

§  103.     Reinforced  Security 

One  method  of  reinforcing  the  security  of  bond  issues  is 
by  means  of  sinking  funds.  The  principles  of  the  method  and 
its  operation  are  related  to  other  incidents  of  bond  financing 
and  are  discussed  in  a  succeeding  chapter.  (See  Chapter  XI.) 
Bonds  so  reinforced  in  security  are  called  sinking  fund  bonds. 

Another  method  of  reinforcing  the  security  of  bonds  is  by 
an  agreement  of  guaranty  made  by  a  third  party,  assuring  per- 
formance by  the  debtor  of  its  obligation  to  pay  the  principal  of 
the  bond,  or  the  interest,  or  both  principal  and  interest.  These 
are  guaranteed  bonds.  While  the  primary  liability  of  the 
debtor  corporation  will  usually  be  secured  by  a  lien  upon  its 
property,  the  reinforcement  of  the  obligation  through  the  sec- 
ondary liability  of  the  guarantor  is  not  secured  by  any  lien 
upon  the  property  of  the  guarantor.  In  dealing  with  guaran- 
teed bonds,  the  circumstances  out  of  which  the  guaranty  arose 
must  be  carefully  examined  in  connection  with  the  contract  of 
guaranty,  in  order  to  form  an  estimate  of  the  degree  of  assur- 
ance afforded.  There  have  been  a  number  of  instances  where 
contracts  of  guaranty  have  been  successfully  repudiated. 

The  terms  of  the  guaranty  may  be  in  a  separate  agreement 
or  else  indicated  upon  the  guaranteed  bonds  themselves.  After 
bonds  have  once  been  issued,  they  have  sometimes  been  called 
for  presentation  and  the  name  of  a  holding  or  other  interested 
company  has  been  indorsed  thereon.  A  guaranty  is  implied 
from  the  presence  of  the  indorsement  and  may  be  enforced 
against  its  indorser  very  much  as  in  the  case  of  any  other 
indorsed  note.    These  are  called  indorsed  bonds. 

§  104.     Taxation  of  Bonds 

Bonds  constitute  personal  property  and  they  are  therefore 
subject  to  taxation  as  such  unless  specifically  exempted  or  sep- 
arately taxed.  The  bonds  represent  a  loan  passing  from  the 
bondholders  to  the  bond  debtor;  the  proceeds  of  this  loan  are 
applied  by  the  borrower  to  the  acquisition  of  property  to  be 


CLASSIFICATION    OF   BONDS  207 

used  in  its  business.  If,  then,  the  property  in  the  hands  of  the 
borrower  is  taxed,  it  would  seem  as  if  the  ones  who  made  the 
acquisition  of  that  property  possible  should  not  in  turn  be 
taxed.  Nevertheless,  the  ownership  of  bonds  has  been  so  often 
thought  of  as  a  prerogative  of  the  rich  man,  that  the  taxation 
of  bonds  has  been  popular  as  a  measure  of  taxing  the  rich, 
while,  as  a  matter  of  fact,  it  taxes  the  poor  just  as  much.  In 
a  few  of  the  states  bonds  are  free  from  taxation  if  the  prop- 
erty mortgaged  is  taxed  within  the  state;  other  states  make 
them  tax-exempt  after  an  initial  recording  tax  is  paid ;  most  of 
the  states  levy  annual  taxes.  Here,  as  in  most  other  cases, 
taxes  are  imposed  unscientifically  and  with  little  equity. 

Where  an  annual  tax  is  levied  it  applies  to  the  principal  of 
the  bonds ;  the  rate  is  usually  expressed  in  a  small  percentage 
which,  by  comparison  with  the  principal  of  the  bond,  makes 
the  amount  of  the  tax  seem  almost  insignificant.  The  bond- 
holder, however,  compares  the  amount  of  the  tax  with  the 
amount  of  interest  which  he  receives  upon  the  bond  and  he 
realizes  how  serious  and  burdensome  the  tax  is;  hence,  he  will 
not  hesitate  to  take  advantage  of  any  opportunity  to  evade  or 
avoid  the  payment  of  the  tax.  In  fact,  many  persons  who  are 
absolutely  honest  and  thoroughly  scrupulous  in  their  dealings 
with  their  fellows  will  not  consider  the  evasion  of  this  tax  as 
a  moral  wrong,  but  will  justify  their  act  as  the  attempted  cor- 
rection of  a  moral  wrong  which  would  be  perpetrated  if  the 
tax  were  actually  collected.  A  tax  of  $15  per  $1,000  of  the 
principal  of  bonds  may  not  seem  to  be  unreasonable,  but  if  the 
bonds  taxed  at  that  rate  yield  only  5  per  cent  per  annum  to 
the  bondholder,  the  tax  is  equal  to  a  levy  of  30  per  cent  upon 
the  income  derived  from  the  investment.  "Which,  then,"  in- 
quires a  leading  writer  on  bond  investments,  "is  more  iniqui- 
tous, the  imposition  of  this  tax  or  its  evasion?  For,  let  it  be 
remembered  that  the  tax  on  bonds  is  seldom  paid  except  by 
those  who  can  least  afford  to  pay:  the  beneficiaries  from  in- 
vested funds.    The  evasion  or  oversight  of  a  mortgage  tax  is 


2o8  FUNDED    DEBT 

diflfictilt  because  of  the  general  practice  of  recording  real  estate 
mortgages."  ^ 

It  has  become  the  ordinary  practice  to  exempt  govern- 
mental and  municipal  bonds  from  taxation,  presumably  upon 
the  theory  that  public  agencies  should  be  given  an  advantage 
over  private  borrowers  in  competing  for  capital,  and  be  enabled 
to  borrow  at  a  lower  cost  than  the  others,  which  they  are  able 
to  do  because  the  investor  will  demand  a  higher  interest  from 
other  borrowers  if  he  knows  that  he  must  pay  out  part  of  that 
interest  income  as  a  tax  upon  his  bondholdings.  A  very  potent 
reason  for  giving  municipal  bonds  this  advantage  has  in  some 
places  been  the  fact  that  it  was  necessary  to  offer  an  induce- 
ment to  attract  again  the  capital  which  had  been  turned  away 
because  of  the  unscrupulousness  of  some  municipalities  in  re- 
pudiating their  obligations. 

The  first  Liberty  Loan  of  1917  was  entirely  tax-exempt, 
while  the  second  Liberty  Loan  was  subject  to  super  taxes  only, 
outside  of  inheritance  taxes.  The  interest  on  these  issues  was 
33/2  and  4  per  cent,  but  if  other  issues  are  put  out  in  the  future 
at  higher  rates  of  interest,  made  similarly  tax-exempt,  the  re- 
sult upon  corporate  borrowing  will  be  that  in  order  to  over- 
come the  advantage  given  to  governmental  borrowings  private 
borrowers  will  need  to  pay  substantially  higher  rates  of  interest. 

A  tax  upon  the  income  from  the  bond  is  unquestionably 
the  most  equitable  method  if  bonds  must  be  taxed  annually; 
but  the  exaction  of  both  income  taxes  and  taxes  upon  the 
principal  makes  the  burden  of  taxation  unfair. 

The  trust  deeds  and  bonds  recite  that  the  sum  due  on  the 
bond  shall  be  paid  by  the  company  "without  deduction  from 
principal  or  interest  on  account  of  any  taxes,  assessments,  or 

other  governmental  charges  which  the Company  may 

be  requested  to  pay  thereon,  or  authorized  to  retain  therefrom, 
by  virtue  of  any  present  or  future  law  whatsoever."  This 
frees  the  bondholder  only  from  liability  on  taxes  which  are 

*  Lawrence  Chamberlain:    "The  Principles  of  Bond  Investment." 


CLASSIFICATION   OF   BONDS  209 

directed  at  the  corporation  itself,  and  which  are  levied  upon  its 
realty,  personalty,  gross  earnings,  organization  taxes,  etc. 
The  enactment  of  the  Income  Tax  Law  brought  out  considera- 
ble misapprehension  of  the  nature  and  extent  of  the  exemption 
above  referred  to.  So  many  bondholders  had  thought  the  ex- 
emption would  cover  taxes  upon  the  income  accruing  from 
the  bonds,  that  a  number  of  leading  and  representative  cor- 
porations announced  their  determination  to  pay  the  income 
tax  for  their  bondholders  rather  than  attempt  to  avail  them- 
selves of  the  full  extent  of  the  limitation  of  liability  to  which 
they  were  entitled  under  the  above  clause.  This,  of  course, 
was  and  continues  to  be  a  purely  voluntary  grant  on  the  part 
of  the  corporations  and  does  not  modify  the  legal  effect  of  pro- 
visions such  as  that  quoted. 


CHAPTER    X 

BOND  INTEREST  AND  NET  YIELD 

§  105.    Interest 

Interest  is  a  payment  for  the  use  of  money.  Its  payment 
implies  the  existence  of  a  fund,  owned  by  the  one  who  receives 
the  interest,  loaned  to  and  placed  in  the  possession  and  for  the 
use  of  another  who  pays  the  interest. 

The  payment  of  interest,  therefore,  represents  a  division 
of  the  return  from  the  use  of  wealth.  The  income  derived 
from  that  use  is  divided  between  the  one  who  pays  the  interest 
and  the  one  who  receives  it.  The  former  borrows  believing 
that  the  Income  over  and  above  the  proportion  paid  by  him 
in  the  form  of  interest  will  represent  a  profit ;  the  latter  lends 
believing  that  in  this  way  he  can  get  the  most  out  of  his  wealth 
without  the  risk  involved  in  his  own  use  of  it;  but  it  is  the 
one  amount  of  wealth  which  produces  a  profit  to  the  one  and 
interest  to  the  other. 

The  buyer  of  capital  stock  expects  that  through  his  invest- 
ment he  will  secure  a  profit  (either  in  the  periodic  payment  of 
dividends  or  in  the  increasing  value  of  the  shares  themselves) 
at  a  rate  somewhat  approximating  that  which  he  would  earn 
if  the  enterprise  were  his  own  individual  business.  Thus  he 
becomes  a  partner  in  the  business ;  his  investment  is  an  invest- 
ment in  the  enterprise  and  the  amount  of  his  profit  or  loss  will 
depend  upon  the  success  or  non-success  of  the  enterprise.  He 
stands  to  win  or  to  lose.  This  is  not  the  case  with  the  bond- 
holder, at  least  not  to  the  same  extent.  He  also  contributes 
to  the  capital  of  the  corporation,  but  his  contribution  is  a  loan 
and  is  not  charged  with  the  entire  risk  of  the  business.  His 
contribution  is  to  be  returned  to  him  whether  the  business  is 

210 


BOND    INTEREST    AND    NET    YIELD  211 

successful  or  not.  The  only  risk  which  he  is  willing  to  assume 
is  the  ordinary  risk  which  every  man  takes  in  making  a  loan. 
In  consideration  of  being  relieved  of  the  risk,  which  will  be 
shifted  to  the  stockholder,  the  bondholder  agrees  to  take  a 
smaller  proportion  of  the  income  accruing  upon  the  capital  of 
the  corporation.  The  rate  of  interest  is,  therefore,  determined 
largely  by  considerations  of  proportion  of  risk  of  the  corporate 
enterprise  of  which  the  bondholder  is  relieved — the  rate  is 
lower  as -the  security  is  greater.  The  greater  security  may  be 
due  to  the  value  of  the  property  mortgaged  to  protect  the  in- 
vestment, as  already  noted,  or  the  stockholders  may  have  as- 
sumed a  degree  of  risk  so  great  as  to  leave  the  loan  capital 
comparatively  free  from  any  risk.  This  latter  situation  is 
further  explained  in  the  chapter  dealing  with  the  proportion 
between  capital  stock  and  funded  debt  in  the  total  capitaliza- 
tion.    (See  Chapter  XII.) 

§  106.     Payment  of  Bond  Interest 

Interest  is  ordinarily  paid  semiannually.  In  standard  bond 
tables  a  semiannual  payment  of  interest  is  assumed.  Thus  the 
interest  dates  will  be  the  first  days  (sometimes  the  fifteenth) 
of  January  and  July,  February  and  August,  March  and  Sep- 
tember, April  and  October,  May  and  November,  June  and  De- 
cember. In  financial  literature  these  methods  are  designated 
by  the  first  initials,  e.g.,  J  and  D.  The  choice  of  months  is 
sometimes  a  matter  of  importance.  The  bulk  of  interest  and 
dividend  payments  is  now  made  in  January  and  July,  hence 
there  is  always  a  heavy  demand  on  the  money  market  for 
funds  with  which  to  make  these  payments,  placing  the  corpor- 
ation at  some  disadvantage  if  it  has  to  borrow  the  actual 
money.  On  the  other  hand,  because  of  the  fact  that  on  these 
dates  much  larger  amounts  of  dividends  and  interest  are  paid 
out  than  at  any  other  time  in  the  year,  considerable  sums  are 
released  for  reinvestment  and  new  issues  of  securities  are  often 
timed  so  as  to  take  advantage  of  this  situation.     It  therefore 


212  FUNDED    DEBT 

becomes  desirable  from  the  standpoint  of  the  investor  that  he 
own  securities  with  interest  dates  approximating  these  so  as  to 
be  in  a  position  to  reinvest  his  income  upon  the  most  advan- 
tageous terms;  of  course,  where  he  does  not  expect  to  reinvest 
the  income,  this  consideration  is  not  a  factor.  In  fact,  where 
the  income  from  bond  investments  is  depended  upon  to  meet 
the  current  expenses  of  the  investor,  it  will  be  to  his  advantage 
to  select  bonds  with  diversified  interest  dates  so  that  his  in- 
come may  be  distributed  more  uniformly  throughout  the 
year. 

The  bond  itself  recites  the  place  where  the  principal  and 
the  interest  are  to  become  payable.  Principal  and  interest  are 
not  necessarily  payable  at  one  and  the  same  place.  A  bond  is 
said  to  be  domiciled  at  the  place  where  the  principal  is  paya- 
ble. Some  of  the  corporations  which  have  large  bond  issues 
maintain  their  own  fiscal  offices  where  the  bonds  are  domiciled 
and  where  interest  is  paid.  Some  issues  are  domiciled  at  a 
banking  institution  other  than  the  office  of  the  trustee.  Many 
of  the  large  corporations  have  the  bonds  domiciled  in  more 
than  one  place,  both  as  to  principal  and  interest,  such  as  New 
York  and  Chicago  for  the  accommodation  of  investors  in  the 
east  and  west,  or  New  York,  London,  and  Paris  if  the  securi- 
ties are  to  be  placed  upon  all  the  markets  centering  at  these 
points.  In  the  case  of  bonds  payable  in  various  countries  the 
language  of  the  bond  must,  of  course,  be  adapted  to  the  cur- 
rency of  those  countries.  For  instance,  "One  thousand  dollars 
in  gold  coin  of  the  United  States  of  America  of  or  equal  to 

the  present  standard  of  weight  and  fineness,    at  its 

office  or  agency  in  the  City  of  New  York;  or,  at  the  option  of 
the  holder,  in  London,  England,  205  pounds,  15  sh.  2d.  Ster- 
ling; or  if  it  were  in  Amsterdam,  Holland,  2480  guilders; 
or,  5160  francs  if  paid  in  France,  Belgium,  or  Switzerland; 
and  to  pay  interest  on  said  principal  amount  from  May  i, 
1907,  in  said  cities  and  countries  respectively,  in  said  respec- 
tive currencies,  at  the  rate  of per  annum." 


BOND    INTEREST    AND    NET    YIELD  213 

§  107.     Nominal  Interest  Rate 

The  rate  of  interest  is  stated  in  the  bond  and  usually  in  the 
trust  mortgage.  But  where  the  mortgage  is  for  a  large  sum 
and  contemplates  future  issues  possibly  at  intervals  of  a  great 
many  years,  the  rate  of  interest  will  not  be  stated  in  the  trust 
mortgage  but  will  be  left  for  the  determination  of  the  directors 
at  the  time  when  bonds  are  actually  issued.  This  is  true  be- 
cause the  market  conditions  may  change  between  issues  and 
it  is  desirable  to  leave  the  directors  free  to  make  the  best  pos- 
sible bargain  at  the  time  of  each  issue.  On  the  open  bond 
market  it  is  not  unusual  to  find  two  or  more  issues  of  the 
same  class  and  kind  of  bonds,  each  bearing  a  different  interest 
rate. 

The  rate  of  interest  stated  in  the  bond  should  be  and  is 
determined  by  the  prevailing  rate  of  interest  upon  loans  made 
under  like  conditions.  Interest  rates  rise  and  fall  through 
competition  for  capital.  The  prevailing  market  rate  must  be 
approximated  by  the  rate  specified  upon  the  average  bond. 
Exceptional  bonds,  strongly  secured,  issued  by  a  company  of 
unquestioned  credit,  engaged  in  a  well-established  and  growing 
business,  may  be  issued  at  a  lower  rate.  Bonds  with  the  or- 
dinary security  and  average  credit  will  be  issued  at  the  prevail- 
ing or  a  higher  rate,  the  rate  increasing  in  proportion  to  the 
newness  of  the  enterprise  or  the  presence  of  other  features 
introducing  risk.  At  the  present  time  there  are  a  few  old 
issues  of  bonds  bearing  interest  at  3^  per  cent.  Issues  of  this 
sort  are  comparatively  rare  among  public  service  corporations, 
other  than  railroads,  whose  bonds  until  recently  were  supposed 
to  be  semi-speculative.  There  are  a  great  many  issues  at  4,  5, 
and  6  per  cent,  together  with  the  fractions  of  one-half  in  be- 
tween. If  all  issues  now  outstanding  are  considered,  the  most 
usual  rates  will  be  found  to  be  4^  and  5  per  cent,  while  among 
the  issues  of  the  last  few  years  6  per  cent  has  been  a  common 
rate.  There  are  a  few  issues  carrying  7  per  cent  interest.  Such 
a  high  interest  rate,  if  borne  by  a  number  of  the  issues  put  out 


214 


FUNDED   DEBT 


during  a  certain  period,  will  reflect  strong  competition;  but  if 
it  is  found  in  comparatively  few  instances,  it  reflects  the  con- 
siderable amount  of  risk  which  the  bondholders  will  be  called 
upon  to  assume.  An  investor  who  is  willing  to  assume  that 
degree  of  risk  will  probably  prefer  to  invest  in  shares  of  stock 
which  present  a  greater  opportunity  for  speculative  profit. 

The  foregoing  remarks  relate  wholly  to  the  stated  interest 
rate,  which  is  called  the  nominal  rate  since  it  is  the  rate  applied 
to  the  par  value  of  the  bonds ;  but  the  bond  itself  may  be  sold 
above  or  below  par,  making  the  actual  interest  income  to  the 
stockholders,  i.e.,  the  effective  rate,  depend  not  upon  the  par 
value  but  upon  the  amount  paid,  and  may  be  greater  or  less, 
according  to  the  discount  or  premium  paid  upon  purchase. 

It  may  be  noted  in  passing  that  usury  laws  do  not  ordina- 
rily apply  to  corporations.  It  is  not  usual  to  have  statutory 
enactments  as  to  interest  rates  upon  corporation  bonds.  A 
proposed  federal  bill  contained  a  provision  limiting  interest  to 
6  per  cent  per  annum.  It  goes  without  saying  that  legislation 
concerning  the  nominal  interest  rate  alone  is  ineffective  and 
meaningless.  It  is  the  effective  interest  rate  which  must  be 
regulated,  but  this  is  so  much  the  product  of  competition  and 
the  relation  between  supply  and  demand  of  capital,  that  its 
regulation  by  arbitrary  authority  seems  a  questionable  under- 
taking. 

§  io8.     Effective  Interest  Rate 

The  effective  interest  rate  is  the  ratio  of  the  amount  paid 
periodically  for  the  use  of  money  to  the  principal  sum  actually 
received  by  the  payer  of  the  interest.  It  is  thus  to  be  distin- 
guished from  the  nominal  interest,  which  is  a  certain  per  cent 
upon  the  face  value  of  a  money  obligation,  even  though  the 
sum  actually  advanced  upon  that  obligation  was  less  or  more 
than  the  face  value  therein  expressed.  It  is  also  to  be  dis- 
tinguished from  the  ratio  of  the  amount  received  as  interest 
by  the  holder  of  the  obligation  to  the  amount  paid  by  him  for 


BOND    INTEREST   AND    NET    YIELD 


215 


the  acquisition  of  that  claim,  this  ratio  being  usually  desig- 
nated net  rate  of  income.  The  interest  paid  by  the  corporation 
and  the  interest  income  received  by  the  bondholder  will  be  the 
same  amount  only  if  the  latter  has  received  his  bond  direct 
from  the  corporation.  They  will  not  agree  if  the  bondholder 
has  come  into  possession  of  his  bonds  through  another,  save 
in  the  unusual  circumstance  of  the  original  holder's  having 
sold  at  a  price  exactly  equaling  the  cost  to  him. 

In  ordinary  commercial  transactions,  a  note  is  discounted 
when  the  interest  upon  the  same  is  deducted  by  the  lender  from 
the  amount  loaned,  that  is,  the  borrower  pays  the  interest  in 
advance.  The  difference  between  the  face  of  the  note  which 
the  borrower  gives  and  the  amount  of  money  which  he  actually 
receives  is  the  discount.^  Ordinarily  notes  which  are  dis- 
counted are  for  very  short  terms  and  the  discount  retained  by 
the  lender  represents  all  the  interest  which  the  borrower  will 
pay  on  that  one  note.  If,  however,  the  lender  retains  a  dis- 
count while  the  borrower  is  still  obligated  to  make  further 
payments  for  interest  at  rates  and  upon  conditions  stated  in 
the  note,  then  the  amount  of  actual  interest  paid  by  the  bor- 
rower is  the  discount  suffered  plus  the  amounts  paid  as  interest. 

§  109.     Issue  of  Bonds  at  Discount  or  Premium 

Similarly,  a  corporation  may  discount  its  bonds.  It  can 
offer  to  accept  an  amount  less  than  the  par  value,  although  it 
will  be  obligated  to  pay  par  upon  maturity.  The  discount  will 
represent  an  advance  payment  for  the  use  of  money,  and  since 
the  bonds  are  currently  interest-bearing,  to  the  nominal  inter- 
est rate  must  be  added  the  rate  prepaid  by  discount,  and  the 
result  will  be  the  effective  interest  rate. 

There  may  be  a  number  of  conditions  warranting  the  issue 


1  There  is  a  slight  difference  between  discount  and  interest  at  the  same  rate.  The 
discount  on  a  note  for  $i,ooq  discounted  for  sixty  days  at  6  per  cent  is  $10,  and  the 
one  discounting  the  note  receives  $990.  This  is  the  ordinary  bank  discount.  The  in- 
terest at  6  per  cent  on  a  loan  of  $990  for  sixty  days  would  have  been  only  $9.90,  how- 
ever— ten  cents  less  than  the  amount  of  the  discount.  In  bond  issues  where  large 
amounts  are  involved,  the  true  discount  should  be  computed  in  order  to  have  it  cor- 
respond with  interest  accruals. 


2l6  FUNDED    DEBT 

of  bonds  at  a  discount.  The  prospective  purchaser  may  con- 
sider himself  entitled  to  a  greater  than  the  nominal  rate  of 
interest,  either  because  of  the  terms  and  conditions  of  the 
bonds  or  because  of  the  risk  of  the  enterprise.  He  takes  that 
extra  interest  by  discounting  the  loan.  The  practical  reason  in 
most  instances  is  that  the  prospective  purchaser  wants  an  op- 
portunity to  profit  through  the  betterment  of  the  corporation's 
credit,  whereby  the  market  price  of  the  bonds  may  rise  nearer 
or  equal  to  par.  Enhanced  market  price  simply  means  that 
investors  will  be  found  who  are  willing  to  buy  the  bonds  on 
the  basis  of  a  net  interest  yield  which  will  more  nearly  approx- 
imate, equal,  or  go  below  (in  the  case  of  bonds  selling  above 
par)  the  nominal  interest  rate  expressed  in  the  bond.  They 
consider  that  the  strength  of  the  bonds  warrants  their  invest- 
ment on  that  basis. 

On  the  other  hand,  the  corporation  may  be  able  to  issue  its 
bonds  above  par.  This  may  result  from  the  fact  that  the  bonds 
carry  a  higher  rate  of  interest  than  that  prevailing  for  invest- 
ments of  that  class.  Supposing  that  there  were  no  other  con- 
siderations operating  upon  the  corporation,  it  might  have  low- 
ered the  interest  rate  and  sold  the  bond  at  exactly  face  value; 
if  it  chose  not  to  do  so,  the  premium  realized  must  be  ac- 
counted for  as  advances  by  the  bondholders  to  offset  in  part 
the  interest  to  be  paid  to  them  by  the  corporation.  In  ultimate 
effect,  the  amount  of  the  premium  is  returned  to  the  bond- 
holders in  periodic  instalments.  From  the  standpoint  of  the 
bondholder,  the  purchase  of  the  bond  may  be  regarded  as  rep- 
resenting a  dual  investment ;  first,  in  a  bond  bearing  the  normal 
rate  of  interest,  and  second,  in  an  annuity  represented  by  the 
premium.  The  difference  between  the  amount  which  he  re- 
ceives upon  the  bond  at  the  specified  rate  of  interest  and  that 
which  he  would  have  received  at  the  theoretical  rate  which 
would  have  sold  the  bond  at  par  instead  of  at  a  premium,  will 
be  the  periodic  payment  upon  the  annuity. 

In  determining  the  nominal  interest  rate  to  be  specified  in 


BOND    INTEREST    AND    NET    YIELD 


217 


a  bond,  it  is  therefore  necessary  to  determine  first  the  price  at 
which  the  bond  is  to  be  sold.  It  is  best,  of  course,  to  arrange 
interest  provisions  so  that  the  bond  may  sell  at  par,  but  this 
is  not  usually  practicable.  In  the  determination  of  the  price, 
the  psychology  of  the  market  is  a  strong  factor  of  which  the 
most  pronounced  phase  is  the  liking  that  a  great  many  invest- 
ors have  for  bonds  selling  at  discount,  on  the  supposition  that 
these  offer  a  better  chance  of  appreciation  than  a  bond  pur- 
chased at  par.  Among  this  class  of  investors  bonds  to  be  sold 
at  a  premium  are  taboo. 

As  a  matter  of  fact  where  the  price  has  been  determined  on 
the  basis  of  net  return,  there  is  no  appreciation,  all  other  things 
being  equal,  in  a  bond  issued  at  a  discount ;  and  there  is  no  de- 
preciation in  a  bond  issued  at  a  premium.  The  net  yield  will 
be  the  same  to  the  bondholder  in  the  long  run;  whether  he 
purchases  a  twenty-year  4  per  cent  bond  at  93.45,  or  a  twenty- 
year  5  per  cent  bond  at  106.55 — ^^'^^  "^^  return  is  4.5  per  cent 
in  both  cases.  In  the  first  instance  the  appreciation  arising 
from  the  accumulation,  as  the  date  of  maturity  draws  near, 
operates  to  restore  the  correspondence  between  the  nominal 
specified  rate  and  the  actual  rate  to  which  the  investor  was  en- 
titled. In  the  second  case  the  depreciation,  as  the  premium 
expires,  accomplishes  the  same  thing  from  an  opposite  direc- 
tion. An  investor  of  the  type  of  mind  which  prefers  a  bond 
selling  at  discount  because  of  the  chance  for  appreciation  will 
seldom  recognize  that  a  5  per  cent  bond  purchased  at  105.97 
when  it  had  fifteen  years  to  run  has  appreciated  in  value  if 
sold  at  103.12  when  only  five  years  of  its  life  remained;  the 
net  yield  when  purchased  was  4.45  per  cent  and  on  the  same 
basis  the  value  at  time  of  sale  would  have  been  102.44. 

Making  all  due  allowances  for  the  temperament  and  psy- 
chology of  the  investor,  it  is  not  good  policy  nor  good  finance 
to  issue  bonds  at  too  great  a  discount.  The  price  at  which  any 
one  issue  is  marketed  may  operate  to  the  disadvantage  of  a 
future  issue.     Moreover,  issuing  bonds  at  a  discount  always 


2i8  FUNDED    DEBT 

requires  the  assumption  of  a  debt  greater  than  necessary.  If 
$1,000,000  is  the  sum  required,  $1,250,000  in  par  value  of 
indebtedness  must  be  issued  if  the  bonds  are  to  be  sold  at  80. 
Calling  the  difference  "prepaid  interest"  or  anything  else 
does  not  alter  the  fact  that  the  borrower  has  had  to  pledge  its 
credit  for  a  greater  sum  than  it  has  received.  Of  course,  if 
proper  accounting  is  followed  and  the  discount  amortized  out 
of  income,  there  is  no  substantial  harm  done.  But  suppose 
that  a  company  with  $50,000  capital  stock  is  limited  to  the 
borrowing  of  only  $150,000,  viz.,  three  times  the  amount  of 
its  capital  stock,  and  that  it  requires  altogether  $200,000  for 
the  completion  of  its  plant.  If  the  stock  were  issued  for  par 
and  the  bonds  at  a  discount  of  20  per  cent,  the  total  proceeds 
will  fall  short  of  the  amount  required  by  $30,000,  and  yet  the 
company  will  have  pledged  its  entire  credit,  leaving  no  basis 
upon  which  to  borrow  the  remainder  of  the  necessary  amount. 

Practically  all  public  utility  commissions  now  exercise  the 
right  of  specifying  the  minimum  per  cent  of  par  or  the  price 
at  which  bonds  may  be  issued ;  in  fact,  they  are  required  to  do 
so  because,  having  certified  to  the  necessity  of  raising  a  speci- 
fied sum  for  certain  purposes  by  the  issue  of  securities,  in  order 
to  determine  the  par  value  of  securities  to  be  authorized  for 
those  purposes  the  commission  has  to  place  the  applicants  upon 
record  as  to  the  price  to  be  realized  upon  sale.  Specific  statu- 
tory regulations  operating  directly  upon  the  corporations  in- 
volved are  not  common.  A  proposed  federal  bill  in  limiting 
the  interest  rate  to  6  per  cent  also  provided  that  the  discount 
should  not  be  "such  that  taking  into  consideration  the  rate  of 
interest  and  the  date  of  maturity  thereof,  the  net  return  to  the 
investor  shall  exceed  7  per  cent  per  annum."  The  statutes  of 
some  of  the  states  provide  that  bonds  may  not  be  issued  at  less 
than  75  or  some  other  percentage  of  par,  but  these  statutes 
usually  are  silent  as  to  the  nominal  rate  of  interest  which  the 
bonds  may  carry. 

The  determination  of  any  commission  as  to  the  price  of 


BOND    INTEREST    AND    NET    YIELD 


219 


issue  never  operates  to  hinder  the  corporation  from  making 
a  better  bargain  with  purchasers.  The  expenditure  of  the  ex- 
cess proceeds  realized  by  reason  of  the  better  bargain  must, 
however,  be  approved  by  the  commission. 

§  no.     Bond  Values 

The  value  of  all  securities  bought  for  investment  purposes 
is,  in  the  last  analysis,  predicated  upon  the  expected  income, 
since  they  are  purchased  for  the  sake  of  income.  "Value  is 
most  significantly  expressed  in  terms  of  income;  indeed,  we 
may  say  yield  is  the  only  common  denominator  of  security 
values."  ^  The  rate  of  income  of  a  security  is  the  ratio  which 
a  certain  amount  periodically  received  upon  the  security  bears 
to  the  price  paid  for  the  security.  Dividends  on  stock  and  in- 
terest on  bonds  are  paid  at  specified  percentages  of  par  value. 
If  par  has  been  paid  for  the  share  of  stock  or  the  bond,  the 
rate  of  dividends  or  interest  will  also  be  the  rate  of  income  to 
the  security  holder;  but  if  he  paid  more  or  less  than  par  for 
the  security,  the  rate  of  income  will  vary  from  the  expressed 
rate  of  dividends  or  interest  to  a  degree  corresponding  to  the 
discount  or  premium  at  which  the  security  was  purchased. 
The  rate  of  income  is  usually  designated  as  the  net  investment 
return  or  the  net  yield. 

More  particularly,  the  net  yield  may  be  either  net  dividend 
yield  or  net  interest  yield,  the  terminology  reflecting  somewhat 
the  nature  of  the  security  to  which  each  is  applied.  The 
former  relates  to  securities  in  which  the  time  element  is  lack- 
ing, such  as  interminable  loans,  but  most  generally  to  stocks, 
hence  the  word  "dividend";  the  latter  relates  to  terminable 
loans  where  the  time  element  is  certain  and  of  the  essence  of 
the  investment. 

§  III.     Net  Dividend  Yield 

The  net  dividend  yield  is  simply  the  ratio  between  a  peri- 

'  Lawrence  Chamberlain:    "The  Principles  of  Bond  Investments." 


220  FUNDED    DEBT 

odic  payment  and  the  amount  invested  to  secure  that  periodic 
payment.  It  is  determined  by  dividing  the  amount  received  by 
the  cost  of  the  security.  For  instance,  if  a  share  of  stock  is 
purchased  at  no  and  the  amount  of  the  dividends  received 
semiannually  is  $5  (5  per  cent  on  par  of  $100),  the  net  divi- 
dend yield  is  5/1 10  or  .454  or  4.54  per  cent.  The  factors  of 
the  computation  are  (i)  the  amount  invested,  (2)  the  amount 
received  upon  the  investment.  Stock  tables  are  available  from 
which  it  is  very  easy  to  tell  at  a  glance  what  the  net  dividend 
yield  is  on  stocks  bought  at  specified  rates. 

A  third  factor  may  enter  into  a  theoretical  study  of  the  net 
dividend  yield,  to  wit,  a  dividend  interval.  The  actual  yield 
of  a  share  of  stock  paying  8  per  cent  annually  (distributed  in 
a  single  dividend  payment)  is  less  than  that  of  a  stock  paying 
4  per  cent  semiannually,  and  still  less  than  that  of  a  stock  pay- 
ing 2  per  cent  quarterly,  since  in  the  case  of  semiannual  pay- 
ments the  net  yield  in  the  second  half  of  the  year  must  be 
increased  by  the  interest  which  the  amount  received  as  divi- 
dends for  the  first  half  may  earn  if  reinvested.  Similarly,  in 
the  case  of  quarterly  dividends,  the  amount  of  dividends  dur- 
ing the  year  must  be  increased  by  the  interest  which  the  2  per 
cent  received  for  the  first  quarter  will  earn  during  the  remain- 
ing nine  months,  the  interest  which  the  second  dividend  will 
earn  for  six  remaining  months,  and  that  which  the  third  divi- 
dend will  earn  for  three  remaining  months.  It  should  be  said, 
however,  that  only  under  exceptional  and  very  close  figuring 
will  this  computation  be  necessary. 

In  the  above  discussion  reference  has  been  made  to  divi- 
dends on  capital  stock,  but  this  is  equally  applicable  to  bonds 
which  run  in  perpetuity,  having  no  date  of  maturity,  or  bonds 
of  such  a  long  period  as  to  be  practically  interminable  so  far 
as  their  present  holders  are  concerned.  The  revenue  received 
from  perpetual  loans  is  not  a  dividend,  since  it  represents  an 
obligatory  payment  on  the  part  of  the  debtor  and  not  a  distri- 
bution of  profits.    Interest  is  an  accruing  claim,  and  bonds  sold 


BOND    INTEREST   AND    NET   YIELD  .221 

between  interest  dates  will  be  sold  at  an  agreed  price  plus  ac- 
crued interest;  shares  of  stock,  however,  are  not  sold  plus 
accrued  dividends  ("dividends-on")  unless  a  dividend  has 
been  actually  declared  and  payment  is  pending.  Interest  which 
is  contingent  upon  the  sufficiency  of  earnings  more  nearly 
resembles  dividends  and  on  the  New  York  Stock  Exchange 
income  bonds  are  required  to  be  quoted  flat,  i.e.,  without  ac- 
crued interest. 

In  the  case  of  redeemable  or  callable  preferred  stocks,  a 
fourth  element  of  time  sometimes  enters  into  the  computation 
of  net  dividend  return.  Where  the  stock  is  affected  by  present 
conditions  indicating  the  probable  redemption  thereof,  the 
computation  will  have  to  consider  the  stock  as  a  redeemable 
security.  Its  value  and  interest  yield  can  be  ascertained  in 
accordance  with  the  method  described  below. 

§  112.     Net  Interest  Yield 

In  the  case  of  securities  having  a  definite  and  fixed  date  of 
maturity,  if  purchased  below  or  above  par,  the  period  to  elapse 
before  redemption  is  a  necessary  factor  in  the  determination  of 
the  value  of  the  bond  and  of  the  interest  yield,  since  it  is  the 
period  during  which  the  discount  or  premium  is  to  be  extin- 
guished and  the  value  of  the  bond  restored  to  par,  at  which 
amount  it  is  payable.  The  net  interest  yield  will  remain  con- 
stant throughout  the  period,  but  the  money  value  of  the  bond, 
that  is,  the  amount  necessary  to  be  invested  to  secure  the  net 
interest  yield  desired,  will  vary,  increasing  or  decreasing 
as  the  date  of  maturity  approaches,  depending  upon  whether 
the  bond  sells  at  a  premium  or  at  a  discount.  In  the  compu- 
tation of  the  present  value  or  of  the  net  yield  of  a  bond  with 
a  definite  and  fixed  date  of  repayment,  there  are  two  elements 
which  were  lacking  in  the  computation  of  net  dividend  yield, 
to  wit,  the  par  value  at  which  the  bond  is  payable  and  the  term 
in  years.  In  this  computation  the  interest  interval  also  be- 
comes a  determining  factor  in  connection  with  the  term  in 


222  FUNDED   DEBT 

years  and  the  compounding  of  interest.     Hence  the  factors 
here  are  the  following: 

1.  Price 

2.  Par  value 

3.  Nominal  interest  rate 

4.  Term  in  years 


,  ,   =  Number  of  interest  periods 
5.    Interest  mterval  J 

Net  interest  yield  and  bond  values  are  worked  out  in  great 
detail  in  books  of  bond  values.  The  computation  is  not  an 
altogether  simple  one  and  in  view  of  the  fact  that  tables  of 
bond  values  are  so  complete  and  so  much  used,  it  is  not  neces- 
sary to  go  into  the  mathematics  of  bond  values.  There  are 
satisfactory  books  on  bond  values  on  the  market,  and  the 
reader  is  referred  to  these  for  a  detailed  study  of  methods  and 
bond  tables. 

§  113.     Accounting  for  Premium  and  Discount  on  Bonds 

Referring  to  bond  tables,  the  value  of  a  3J/2  per  cent 
twenty-year  bond  to  yield  5  per  cent  net  interest  yield  is  found 
to  be  $811.73,  its  value  increasing  each  interest  period  as  fol- 
lows: 

Value  at  Accumulation 

Close  of  Period       During  Period  - 

Purchased    811.73  

First  period 814.52  2.79 

Second  period 817.39  2.87 

Third  period 820.32  2.93 

Fourth  period 823 .  33  3.01 

Fifth  period 826.41  3.08 

Sixth  period 829.57  3-i6 

The  purchaser  of  the  bond  would  set  it  up  in  his  invest- 
ment account  at  cost,  $81 1.73.  At  the  close  of  the  first  interest 
period  he  will  credit  to  his  income  account  "Interest  Rev- 
enues," $17.50,  the  amount  of  the  coupon.  He  will  also  credit 
to  his  income  account  "Appreciation  of  Bond  Value,"  $2.79. 


BOND    INTEREST    AND    NET    YIELD  223 

The  total  amount  of  the  income  for  the  period  from  his  invest- 
ment will  thus  be  $17.50  plus  $2.79,  or  $20.29.  At  the  close 
of  the  second  interest  period  he  will  credit  to  "Appreciation 
of  Bond  Value,"  $2.87 ;  for  the  third  period  $2.93,  etc. 

On  the  other  hand,  the  corporation  which  issues  the  bond 
must  recognize  the  full  liability  of  $1,000.  It  used  to  be  the 
practice  to  carry  the  amount  of  discount,  $188.27  in  the  above 
illustration,  into  the  "Cost  of  Road"  or  "Plant"  account,  ap- 
pearing upon  the  assets  side  of  the  balance  sheet.  The  cor- 
rect practice  and  that  which  is  now  required  is  for  the  corpora- 
tion to  set  up  the  amount  of  the  discount  in  a  suspense  account, 
"Unamortized  Debt  Discount  and  Expense."  At  the  close  of 
the  first  interest  period  it  will  charge  to  its  income  account 
"Interest  Accrued  on  Funded  Debt,"  $17.50.  It  will  also  carry 
to  an  income  account,  "Amortization  of  Debt  Discount  and 
Expense,"  $2.79.  In  making  the  latter  entry  the  account  "Un- 
amortized Debt  Discount  and  Expense"  is  credited,  decreasing 
the  balance  to  $185.48.  The  account  titles  used  here  for  the 
accounting  by  the  corporation  are  those  in  the  Uniform  Sys- 
tem of  Accounts  prescribed  by  the  New  York  Public  Service 
Commissions.  The  full  text  of  the  instructions  for  these  ac- 
counts is  as  follows: 

"Unamortized  Debt  Discount  and  Expense.  When  funded 
debt  securities  and  other  evidences  of  indebtedness  are  dis- 
posed of  for  a  consideration  whose  cash  value  is  less  than  the 
sum  of  the  par  value  of  the  securities  or  other  evidences  of 
indebtedness  and  the  interest  thereon  accrued  at  the  time  the 
transfer  takes  place,  the  excess  of  such  sum  of  the  par  value 
and  accrued  interest  over  the  cash  value  of  the  consideration 
received  shall  be  charged  to  this  account.  To  this  account 
shall  also  be  charged  all  expense  connected  with  the  issue  and 
sale  of  evidences  of  debt,  such  as  fees  for  drafting  mortgages 
and  trust  deeds,  fees  and  taxes  for  recording  mortgages  and 
trust  deeds,  cost  of  engraving  and  printing  bonds,  certificates 
of  indebtedness,  and  other  commercial  paper  having  a  life  of 


224 


FUNDED    DEBT 


more  than  one  year,  fees  paid  trustees  provided  for  in  mort- 
gag-es  and  trust  deeds,  fees  and  commissions  paid  underwriters 
and  brokers  for  marketing  such  evidences  of  debt,  and  other 
like  expenses.  At  or  before  the  close  of  each  fiscal  period 
thereafter,  a  proportion  of  such  discount  and  expense  based 
upon  the  life  of  the  security  to  maturity  shall  be  credited  to 
this  account  and  charged  to  the  account  'Amortization  of  Debt 
Discount  and  Expense.'  Such  discount  and  expense  may,  if 
desired,  be  amortized  more  rapidly  through  charges  of  all  or 
any  part  of  it,  either  at  the  time  of  issue  or  later,  to  the  ac- 
count 'Other  Deductions  from  Surplus.'  " 

"Amortization  of  Debt  Discount  and  Expense.  Charge  to 
this  account  at  or  before  the  close  of  any  fiscal  period  that  pro- 
portion of  the  unamortized  discount  and  debt  expense  on  out- 
standing debt  w^hich  is  applicable  to  the  period.  This  propor- 
tion shall  be  determined  according  to  a  rule,  the  uniform  ap- 
plication of  which  during  the  interval  between  the  issue  and 
the  maturity  of  any  debt  will  completely  amortize  or  wipe  out 
the  discount  at  which  such  debt  was  issued  and  the  debt  ex- 
pense connected  therewith.  Such  amortization  may  at  the 
option  of  the  corporation  be  earlier  effected  by  crediting  all  or 
any  portion  of  such  discount  and  debt  expense  to  the  account 
'Other  Deductions  from  Surplus,'  immediately  upon  issue  of 
the  debt  or  thereafter." 

Considering  now  the  situation  of  a  bond  sold  at  a  premium, 
upon  again  referring  to  bond  tables  the  values  of  a  6  per  cent 
twenty-year  bond  yielding  5  per  cent  are  noted  as  follows: 

Value  at  Depreciation 

Close  of  Period  During  Period 

Purchased  $1,125.51  .... 

First  period 1,123.65  1.86 

Second  period 1,121.74  1.91 

Third  period 1,119.79  1.95 

Fourth   period 1,117.78  2.01 

Fifth  period 1,115.73  2.05 

Sixth  period 1,113.62  2. II 


BOND    INTEREST   AND    NET    YIELD 


225 


The  purchaser  of  the  bond  in  this  case  will  set  up  the  bond 
in  his  investment  account  at  the  value  of  $1,125.51.  At  the 
close  of  the  first  period  he  will  credit  to  his  income  account 
"Interest  Revenue,"  $30,  and  will  charge  to  an  income  account 
"Decrease  in  Bond  Value,"  $1.86,  leaving  a  net  credit  to  in- 
come of  $28.14.  At  the  close  of  the  second  period  he  will 
charge  to  income  $1.91 ;  for  the  third  period  $1.95,  etc. 

The  corporation,  on  the  other  hand,  must  again  recognize 
the  par  value  of  the  bond  among  its  liabilities.  The  amount  of 
the  premium  realized  will  then  be  set  up  among  other  deferred 
credit  items  by  a  credit  to  account  "Unextinguished  Premiums 
on  Outstanding  Funded  Debt."  At  the  close  of  the  first  inter- 
est period,  in  addition  to  charging  to  income  account  "Interest 
Deductions  for  Funded  Debt,"  it  will  also  credit  to  income  ac- 
count "Release  of  Premiums  on  Funded  Debt"  the  amortiza- 
tion of  $1.86,  leaving  the  net  charge  for  interest  $28.14.  In 
crediting  the  account  "Release  of  Premiums  on  Funded  Debt" 
the  account  "Unextinguished  Premiums  on  Outstanding 
Funded  Debt"  is  debited,  reducing  its  balance  to  $123.65.  The 
account  titles  used  are  those  in  the  Uniform  System  of  Ac- 
counts prescribed  by  the  Interstate  Commerce  Commission  and 
the  full  text  of  the  instructions  for  these  accounts  is  here 
given : 

"Unextinguished  Premiums  on  Outstanding  Funded  Debt. 
When  any  issue  of  funded  debt  is  sold  at  a  premium  or  issued 
for  a  consideration  the  actual  money  value  of  which,  at  the 
time  of  the  sale  of  the  funded  debt,  is  greater  than  the  par 
value  of  the  securities  sold  and  accrued  interest  thereon,  if 
any,  the  premium  so  realized  should  be  credited  to  a  ledger  ac- 
count provided  for  discounts  and  premiums  on  the  class  of 
funded  debt  sold.  If  the  net  of  the  balances  in  the  Discounts 
and  Premiums  accounts  for  all  classes  of  funded  debt  sold  is 
a  credit  balance,  the  amount  should  be  included  in  this  account. 
At  or  before  the  close  of  any  fiscal  period  there  should  be  cred- 
ited to  the  Income  of  that  period  (and  debited  to  the  Discounts 


226  FUNDED    DEBT 

and  Premiums  accounts  in  which  the  premium  is  carried)  such 
proportions  of  the  premiums  on  outstanding  debt  obhgations 
as  may  be  applicable  to  that  period.  This  proportion  may  be 
determined  according  to  a  rule,  the  uniform  application  of 
which  throughout  the  interval  between  the  date  of  sale  and  the 
date  of  maturity  of  the  debt  will  extinguish  the  premium  at 
which  such  debt  was  sold." 

"Interest  Deductions  for  Funded  Debt.  This  account 
should  include  interest  on  funded  debt  issued  or  assumed  by 
the  accounting  company  which  has  accrued  during  the  period 
for  which  the  Income  Account  is  stated." 

In  the  above  illustrations  the  assumption  has  been  that  the 
seller  at  discount  will  use  the  same  method  of  writing  off  the 
discount  suffered  as  the  purchaser  will  use  for  the  discount 
earned.  The  seller,  however,  is  under  no  obligation  to  recog- 
nize upon  its  books  the  sale  of  the  bonds  on  a  "basis" ;  its  only 
obligation  is  that  of  properly  recording  the  fact  that  a  discount 
has  been  suffered  which  must  be  made  good  out  of  accumu- 
lated or  current  income.  If  it  has  a  surplus  account  which  will 
stand  it,  the  corporation  may  charge  against  it  the  entire 
amount.  This  practice,  although  allowed  by  the  accounting 
orders  quoted,  is  not  a  theoretically  correct  one,  but  has  much 
to  commend  it  by  reason  of  its  simplicity.  The  next  simpler 
method  is  that  of  writing  off  the  total  amount  in  equal  annual 
instalments.  The  method  of  equal  annual  instalments  may 
likewise  be  applied  to  the  accounting  for  premiums  earned,  but 
the  accounting  instructions  quoted  apparently  do  not  permit 
these  premiums  to  be  credited  direct  to  the  surplus  account. 

If  some  bonds  of  one  issue  have  been  sold  at  a  discount 
and  others  at  a  premium,  it  is  generally  proper  for  the  cor- 
poration to  offset  one  against  the  other,  for  it  is  dealing  with 
the  debt  in  total.  If  bonds  of  one  issue  are  sold  at  a  discount 
and  those  of  another  issue  at  a  premium,  the  discount  and  pre- 
mium should  be  separately  recorded  and  the  one  should  not 
be  applied  to  offset  the  other.;  especially  would  such  a  practice 


BOND    INTEREST    AND    NET    YIELD  227 

be  bad  accounting  if  the  two  issues  were  at  different  interest 
rates. 

§114.     Interest  Payable  in  Gold  Coin  or  Legal  Tender 

By  the  terms  of  many  issues,  interest  is  payable  in  gold 
coin,  in  other  cases  in  legal  tender.  The  actual  sacrifice  made 
by  the  payer  and  the  real  benefit  obtained  by  the  payee  may  at 
any  certain  time  be  quite  far  from  that  contemplated  when 
the  bond  was  first  issued  or  purchased,  since  the  purchasing 
power  of  money  may  have  increased  or  decreased  since  then. 
If  some  method  could  be  devised  by  which  the  interest  pay- 
ment could  be  regulated  according  to  the  prevailing  value  of 
money  in  terms  of  purchasing  power,  a  more  stable  basis  of 
financing  and  investing  might  be  possible,  but  it  is  very  doubt- 
ful if  any  such  reform  can  be  expected  at  an  early  date. 


CHAPTER    XI 

MATURITY,   REFUNDING,   AND   REDEMPTION 
OF   BONDS 

§115.     Permanency  of  Funded  Debt 

The  bulk  of  corporate  funded  debt  now  outstanding  rep- 
resents loan  capital  intended  to  be  fully  as  permanent  as  the 
share  capital  itself.  It  is  intended  to  continue  throughout  the 
entire  period  of  operations;  and  the  operations  of  public 
service  corporations,  in  spite  of  limitations  upon  corporate 
existence  in  many  charters,  are  presumed  to  be  in  perpetuity. 
On  the  basis  of  this  theory  and  presumption  it  would  seem 
that  perpetual  funded  debt  (maturing  only  upon  dissolution  of 
the  corporation  or  the  abandonment  of  operations)  would  be 
the  rule  and  not  the  exception  among  public  service  corpora- 
tions. Although  none  of  the  present  outstanding  issues  in  this 
country  are  so  in  form  and  name,  they  are  such  in  fact,  irre- 
spective of  indicated  dates  of  maturity  more  or  less  distant. 
The  proposed  maturity  and  payment  are  mere  incidents  of 
general  financing  operations.  When  the  bonds  fall  due  they 
are  refunded  by  exchange  or  out  of  the  proceeds  of  a  new 
issue,  so  that  the  debt  itself  will  continue  in  perpetuity  al- 
though its  form  may,  many  times,  be  modified. 

In  addition  to  the  theory  underlying  the  utilization  of  loan 
capital,  there  is  also  a  principle  of  investment  which  would 
logically  lead  to  the  issue  of  interminable  bonds.  Bonds  are 
not,  as  a  rule,  bought  with  the  expectation  of  realizing  profit 
upon  resale  or  redemption;  they  are  bought  for  investment 
purposes,  that  is,  they  are  held  for  the  income  which  they 
produce.  Hence,  the  owner  of  a  bond  fully  satisfactory  as  to 
security  and  income  does  not  want  to  part  with  it;  it  will  be 

228 


REFUNDING    AND    REDEMPTION    OF    BONDS        229 

more  agreeable  and  economical  for  him  to  hold  it  rather  than 
to  take  the  trouble  and  chance  of  finding  some  other  invest- 
ment fully  as  satisfactory,  and  possibly  suffering  loss  of  in- 
come between  the  date  when  he  had  to  relinquish  his  holdings 
and  the  reinvestment  of  the  proceeds.  Especially  in  trust 
funds  and  estates,  the  maintenance  of  a  fixed  status  is  very 
much  desired,  and  reinvestment  is  a  contingency  to  be  avoided. 
Bonds  comprise  the  bulk  of  the  investments  so  held. 

§  116.     Interminable  and  Extra-Long-Term  Bonds 

Governmental  securities,  supported  by  the  credit  of  the 
government,  and  therefore  supposed  to  possess  a  sufficient  de- 
gree of  stability  and  assurance,  respond  to  the  principle  of  in- 
vestment above  expressed.  In  England  interminable  securi- 
ties issued  by  private  corporations  are  not  uncommon.  In 
this  country  such  issues  are  very  rare;  indeed,  the  perpetual, 
deferred,  interest-bearing  stock  certificates  of  the  Public  Ser- 
vice Corporation  of  New  Jersey  probably  constitute  an  isolated 
instance  of  the  kind. 

Closely  allied  to  interminable  bonds  are  those  with  a  date 
of  maturity  so  far  removed  as  to  make  nil  the  effect  of  matur- 
ity upon  any  considerations  of  rate  of  income,  market  condi- 
tions, etc.  Bonds  maturing,  say,  500  years  from  date  of  issue 
fall  within  this  class.  In  the  public  service  corporations  field 
these  are  almost  as  rare  as  interminable  bonds ;  the  500-year 
first  mortgage  gold  bonds  of  the  Commercial  Cable  Company, 
maturing  in  the  year  2397,  probably  represent  almost  the  sole 
instance. 

In  the  case  of  both  interminable  and  extra-long-term  bonds 
the  holder  is  aware  that  sale  of  the  bond  is  his  only  means  of 
liquidating  the  investment,  hence  the  value  of  the  bond  will 
depend  upon  the  relation  of  its  interest  rate  to  the  rates  pre- 
vailing at  the  time  of  offer  for  sale:  the  possibility  of  the  bond 
being  redeemed  at  Its  par  will  have  practically  no  effect  on  the 
market  price.    Of  course,  the  question  of  security  will  have  its 


230 


FUNDED    DEBT 


due  weight  as  in  any  class  of  bonds.  As  a  rule,  the  shorter  the 
life  of  a  bond,  the  more  effectively  will  the  face  value  at  which 
it  is  redeemable  control  the  present  value. 

§  117.     Long-Term  Bonds 

While  fundamental  theories  and  principles  warrant  the  use 
of  extra-long-term  bonds,  many  important  considerations  ren- 
der expedient  a  limitation  of  the  life  of  the  debt  to  a  reason- 
able term  of  years.  The  funded  debts  of  many  corporations 
constitute  a  substantial  part  of  their  total  capitalization,  and 
the  interest  charges  thereupon  are  of  such  large  amounts  that 
even  slight  changes  in  the  rates  of  interest  will  materially 
affect  the  net  corporate  income  and  profits  accruing  to  the 
stockholders.  Accordingly,  the  fundamental  principles  of  the 
theory  of  trading  on  the  equity  recjuire  the  most  cautious  bar- 
gaining in  this  very  respect  in  order  that  the  stockholders  may 
receive  the  full  benefit  of  the  transaction.  Questions  of  public 
policy  are  also  involved,  for  it  is  easier  to  regulate  the  rate 
and  disposition  of  profits  than  it  is  to  regulate  or  modify  fixed 
charges.  For  these  reasons  the  debtor  corporation  ought  to  be 
placed  in  a  position  to  take  advantage  of  the  shifting  interest 
rates  to  replace  its  present  obligations  with  those  carrying  a 
lower  rate  of  interest,  reducing  the  annual  fixed  charges,  or 
making  possible  the  extension  of  the  enterprise  from  the 
proceeds  of  additional  bonds  without  material  increase  in  the 
burden  of  interest  charges.  To  all  of  these  considerations 
must  be  added  the  decided  preference  of  investors  for  bonds  of 
a  reasonably  limited  life,  so  that  the  price  of  issue,  market 
price,  rate  of  income,  etc..  may  reflect  the  par  value  of  the 
bond  by  anticipating  payment  upon  maturity. 

The  period  of  years  to  which  the  life  of  bonds  is  usually 
limited  is  thirty,  forty,  or  fifty  years,  with  the  five-yearly 
periods  in  between.  These  bonds  fall  under  the  general 
designation  of  long-term  bonds.  Bonds  covering  a  period 
of  less  than  ten  vears  are  classified  as  short-term  bonds. 


REFUNDING   AND    REDEMPTION    OF   BONDS       231 

The  limitation  of  the  period  is  controlled  by  a  number  of 
considerations.  The  use  of  the  proceeds,  for  instance,  may 
be  a  very  important  consideration,  as  in  the  case  of  equipment 
bonds,  or  where  the  proceeds  are  to  be  applied  to  the  con- 
struction of  a  building,  or  where  the  operations  are  to  be  con- 
ducted under  a  franchise  for  a  limited  number  of  years.  In 
all  these  instances  the  nature  of  the  assets  to  be  acquired  and 
the  term  of  probable  service  will  govern  the  duration  of  the 
life  of  the  bonds.  Undoubtedly  the  most  potent  considerations 
will  be  those  of  prevailing  interest  rates  and  the  conditions 
under  which  the  issue  is  introduced.  A  new  corporation,  for 
instance,  lacking  strong  financial  connections,  or  perhaps  rep- 
resenting a  reorganization,  or  resting  under  some  other  dis- 
advantage which  will  require  the  issue  of  bonds  to  be  at  a 
rate  of  interest  (also  considering  the  price  of  issue)  higher 
than  that  warranted  under  good  market  conditions  or  with 
recognized  credit,  should  limit  the  term  of  the  bonds  to  a 
period  no  longer  than  that  absolutely  necessary  to  carry  the 
corporation  safely  into  a  stage  when  a  more  advantageous 
bargain  will  be  possible.  Conversely,  an  issue  made  at  a  time 
of  low  interest  rates  and  under  very  favorable  conditions 
should  be  for  as  long  a  term  as  possible,  with  due  consideration 
for  the  existing  financial  practice,  and  the  temperament  of 
prospective  investors,  to  save  the  necessity  of  refunding  at  a 
time  when  an  equally  advantageous  bargain  may  not  be 
possible. 

§118.     Short-Term  Bonds  and  Notes 

Under  this  general  designation  are  included  all  evidences 
of  indebtedness  running  for  a  period  ordinarily  placed  at  ten 
years  or  less.  Their  place  in  finance  is  to  supply  capital  for 
purely  temporary  purposes,  or  to  serve  as  measures  of  financial 
"first-aid"  so  that  they  may  carry  the  corporation  over  to  a 
time  when  it  will  be  able  to  place  an  issue  of  long-term  bonds 
to  advantage.    Over  $200,000,000  in  securities  of  this  nature 


232 


FUNDED   DEBT 


were  placed  upon  the  market  in  1907  and  1908.  Those  were 
years  of  panic  and  depression  when  it  was  well  nigh  impossible 
to  market  any  bonds,  even  at  a  high  rate  of  interest,  so  that 
short-term  notes  were  freely  resorted  to,  running  for  periods 
from  one  to  three  and  in  some  instances  five  years.  It  was 
then  expected  that  before  maturity  the  market  would  improve 
and  interest  rates  return  to  normal.  The  expectation  was  not 
realized.  The  notes  matured  and  had  to  be  extended  or  re- 
funded out  of  the  proceeds  of  another  issue  of  notes,  while 
additional  new  issues  of  short-term  notes  were  being  con- 
stantly placed  upon  the  market.  Early  in  19 14,  long  before  the 
beginning  of  the  Great  War  which  caused  another  financial 
relapse,  it  was  estimated  that  the  total  outstanding  short- 
term  note  issues  had  passed  the  $500,000,000  mark  in  par 
value.  It  must  be  remembered  not  only  that  these  were  issued 
at  comparatively  high  rates  of  interest  originally,  but  also  that 
every  maturing  issue  was  renewed  at  equally  high  if  not  higher 
rates  and  with  considerable  additional  expense  in  commis- 
sions, etc.  The  device  thus  proved  very  costly,  because  it  was 
resorted  to  early  in  the  development  of  a  rising  market  and 
maturities  were  not  placed  safely  within  the  return  swing  of 
the  cycle ;  in  a  falling  market  the  device  would  have  been  very 
economical. 

A  material  incentive  to  short-term  financing  began  to  be 
apparent  at  about  that  same  time  (1907).  The  provisions  of 
public  utility  laws  permitting  the  issue  of  notes  for  one  year  or 
less  without  the  authorization  of  regulating  commissions,  and 
with  the  possibility  of  unlimited  renewal  (only  two  states  re- 
quiring authorization  for  renewal  of  funded  debt),  temporarily 
placed  a  premium  on  short-term  financing.  Regulation  was 
new;  corporations  did  not  know  what  to  expect,  and  preferred 
to  wait  and  see  what  others  got;  the  commissions  themselves 
were  new  to  their  tasks  and  worked  slowly  at  a  time  when 
quick  action  was  most  necessary. 

Another  very  important  consideration  influencing  the  issue 


REFUNDING   AND    REDEMPTION    OF    BONDS       233 

of  short-term  securities  since  then  has  been  the  discovery  of  a 
lively  demand  for  investments  of  just  such  a  nature.  Cor- 
porations which  at  certain  seasons  had  great  amounts  of  cash 
on  band  found  it  profitable  to  invest  these  sums  in  short- 
term  securities  which  a  few  months  later  could  readily  be  con- 
verted without  loss  into  cash  to  meet  the  demands  of  their  own 
business.  So  much  has  this  method  of  investment  come  into 
favor  that  there  are  now  investment  brokers  who  will  so  an- 
ticipate the  needs  of  their  various  clients  as  to  be  able  quickly 
to  transfer  the  investment  of  the  one  wishing  to  reconvert  into 
cash  to  another  who  is  ready  to  invest  a  seasonal  cash  sur- 
plusage. 

§  119.     Redeemable,  Callable,  and  Optional  Bonds 

The  maturity  of  a  bond  may  or  may  not  fall  into  a  period 
when  the  corporation  can  refund  the  obligation  advantage- 
ously. In  the  meantime  many  contingencies  may  arise  because 
of  which  the  corporation  will  want  to  retire  a  certain  issue  of 
bonds  before  their  maturity.  That  may  be  done  as  an  incident 
of  reducing  the  funded  debt,  or  for  the  consolidation  of  a 
number  of  issues  under  one  general  mortgage,  or  the  better 
securing  of  another  bond  issue,  or  it  may  form  a  part  of  the 
reorganization  of  the  company's  finances  in  order  to  refund  at 
a  lower  interest  rate,  or  to  reacquire  for  the  purposes  of  sink- 
ing funds.  The  bondholder  would  not,  of  course,  be  under 
any  obligation  to  relinquish  the  claim  before  its  maturity,  and 
were  the  corporation  forced  to  resort  to  individual  bargaining 
every  time  it  wanted  to  retire  or  refund  certain  of  its  bonds, 
it  would  be  very  badly,  if  not  hopelessly,  handicapped.  As  a 
measure  of  protection,  therefore,  the  corporation  often  re- 
serves to  itself  the  right  to  redeem  the  bond  before  maturity. 
Bonds  issued  pursuant  to  such  reservation  are  usually  termed 
redeemable,  callable,  or  optional.  The  option  may  be  reserved 
in  provisions  whereby  the  corporation  may  "redeem"  the  bonds 
at  any  time,  after  some  particular  date,  or  within  a  fixed 


234 


FUNDED    DEBT 


period.  The  term  "optional"  is  applied  especially  when  the 
option  may  be  exercised  within  a  period  nearer  to  the  time  of 
maturity  than  to  that  of  issue. 

It  may  also  be  provided  that  the  bonds  to  be  "called"  shall 
be  drawn  by  lot  at  stated  intervals,  the  result  advertised  in  the 
papers,  and  the  bonds  immediately  retired.  Bond  issues  of  this 
kind  hold  forth  certain  disadvantages  to  the  investor.  He  will 
be  required  to  be  on  the  lookout  for  advertisements  as  to  lot 
drawings ;  these  he  may  or  may  not  see,  but  the  mere  publica- 
tion of  the  notice  will  stop  interest  accruals.  Then,  again,  out 
of  a  number  of  bonds  of  the  same  issue  held  by  one  person, 
only  one  or  two  may  happen  to  be  drawn,  putting  him  to  the 
trouble  of  reinvesting  the  comparatively  small  sum  realized 
upon  the  redeemed  bonds.  No  matter  what  the  form  in  which 
the  corporation  is  privileged  to  exercise  the  option,  where  the 
bonds  are  callable,  redeemable,  or  optional,  the  bondholder  is 
subject  to  the  contingency  of  being  called  upon  to  reassume 
sooner  than  anticipated  the  care  and  labor  of  making  a  new 
commitment  of  capital.  He  may  often  be  required  to  re- 
linquish an  especially  desirable  investment  for  a  less  satis- 
factory one,  since  naturally  a  corporation  would  seldom  exer- 
cise its  option  unless  it  were  occupying  a  strong  financial  posi- 
tion; if  its  situation  were  otherwise  it  would  probably  be  able 
to  reacquire  its  bonds  upon  a  more  advantageous  basis  by 
purchasing  in  the  open  market. 

In  the  attempt  to  compensate  the  bondholder,  at  least  in 
part,  for  the  disadvantage  of  being  forced  to  relinquish  a  claim 
before  maturity,  the  provisions  reserving  to  the  corporation 
the  right  to  redeem  or  call  its  bonds  usually  require  the  pay- 
ment of  a  premium,  or  else  fix  a  certain  amount  above  par  at 
which  the  bonds  shall  be  redeemed,  e.g.,  102,  103,  or  no. 
Even  such  a  provision  may  sometimes  operate  to  the  dis- 
advantage of  the  bondholders,  for  it  will  set  a  limitation  upon 
the  market  value  of  the  bonds.  Were  it  not  for  the  limitation, 
the  bonds  might  sell  at  a  much  higher  figure,  but,  obviously, 


REFUNDING    AND    REDEMPTION    OF    BONDS 


235 


few  would  care  to  purchase  a  bond  at  a  higher  price  than  that 
fixed  for  redemption,  in  the  face  of  even  slight  probability  that 
the  option  would  be  exercised. 

§  120.     Convertible  Bonds 

Convertible  bonds  are  those  carrying  with  them  an  option, 
vested  in  the  bondholder,  to  exchange  the  bond  for  some  other 
security,  usually  shares  of  stock,  in  certain  proportions  and 
upon  the  dates  or  within  the  periods  fixed  for  conversion. 
There  are  instances  where  bonds  have  been  convertible  for  the 
bonds  of  another  issue  instead  of  for  a  share  of  stock,  as  for 
example,  an  unsecured  bond  convertible  into  a  secured  bond. 

The  convertible  feature  generally  renders  the  bond  more 
attractive.  If  convertible  into  stock,  it  superimposes  upon  the 
security  of  the  investment  the  speculative  possibility  of  realiz- 
ing profits  through  the  increased  market  value  of  the  stock 
into  which  it  is  convertible.  If  convertible  into  other  bonds,  it 
may  hold  forth  the  possibility  of  further  safeguarding  the 
investment  by  substituting  a  better  secured  bond. 

§  121.     Redemption  of  Debt  Upon  Maturity 

Most  of  the  foregoing  has  related  to  indebtedness  intended 
to  run  in  perpetuity.  Nevertheless,  although  the  debt  itself 
may  be  intended  to  be  continuing  so  far  as  the  corporation 
is  concerned,  the  bond  which  for  the  time  being  constitutes 
the  evidence  of  the  debt  must  be  paid  at  maturity.  The  bond 
expresses  a  money  indebtedness  and  when  it  matures  the  bond- 
holder is  entitled  to  demand  payment  in  cash  according  to  the 
terms  of  the  bond;  if  he  accepts  anything  else,  say,  a  bond  of 
a  refunding  issue,  his  acceptance  is  a  matter  of  bargaining  and 
of  choice.  The  provisions  of  the  bond  which  relate  to  pay- 
ment are  therefore  of  importance. 

The  bond  usually  describes  specifically  the  medium  of  pay- 
ment, and  in  this  respect  bonds  are  classifiable  into  gold  bonds, 
calling  for  payment  in  "gold  of  the  present  standard  of  weight 


236  FUNDED   DEBT 

and  fineness,"  and  legal  tender  bonds,  payable  in  whatever  may 
constitute  legal  tender  at  the  time  of  payment — sometimes 
called  currency  bonds.  Silver  bonds  are  not  general  now,  but 
they  have  been  common  in  countries  where  silver  standards 
prevailed. 

This  whole  subject  of  the  medium  of  payment  is  of  much 
more  importance  than  is  generally  supposed.  So  far  it  has  re- 
ceived little  beyond  mere  academic  attention.  For  a  number 
of  years  the  purchasing  power  of  gold  has  been  steadily  de- 
creasing; a  bond  purchased  fifty  years  ago  and  now  paid  in 
gold  according  to  its  terms  will  not  return  to  the  erstwhile 
holder  a  sum  of  money  equal  in  purchasing  power  to  the  sum 
which  was  originally  given  for  the  bond,  although  the  amounts 
are  expressed  in  an  equal  number  of  dollars  and  cents.  At 
this  particular  moment  (April,  1918)  the  depreciation  in 
the  value  of  gold  has  become  serious;  the  holder  of  bonds 
maturing  today  will  probably  do  better  to  accept  a  refunding 
bond  than  to  accept  paym.ent  in  cash.  It  is  probable  that  a  few 
years  hence  the  purchasing  power  of  gold  will  again  tend  up- 
wards, so  that  bonds  maturing  then  may  bring  to  the  holders 
a  sum  of  money  of  greater  purchasing  power  than  that  which 
was  made  available  to  the  corporation  at  the  time  of  issue. 
To  equalize  these  fluctuations,  both  in  legal  tender  and  gold, 
some  have  proposed  that  bonds  should  be  made  payable  upon 
maturity  in  such  a  way  that  the  amount  then  received  might 
approximate,  in  terms  of  purchasing  power  of  commodities, 
the  value  of  the  sum  originally  accepted.  If  this  were  done 
to  any  large  extent,  however,  the  use  of  index  figures  in  mone- 
tary transactions  would  have  to  be  standardized  and  generally 
adopted. 

§  122.     Amortization  of  Debt 

Where  the  funded  debt  represents  loan  capital  and  is  in- 
tended to  be  a  continuous  one,  even  though  specific  issues  may 
mature  and  be  succeeded  by  other  issues,  there  is  no  sugges- 


REFUNDING   AND    REDEMPTION    OF   BONDS       237 

tion  or  necessity  of  wiping  out  the  debt  either  gradually  or 
upon  any  specified  date.  The  immediate  burden  of  loan  capital 
upon  the  corporate  income  is  for  interest  alone ;  the  net  earn- 
ings beyond  the  interest  payments  accrue  to  the  benefit  of  the 
stockholders — those  who  are  trading  on  the  equity.  To  pro- 
vide for  the  extinguishihg  of  the  debt  would  be  to  burden  the 
income  with  periodic  appropriations  toward  the  principal  of 
the  debt.  A  long  time  has  elapsed  since  public  service  corpora- 
tions have  been  allowed  to  earn  anything  more  than  a  reason- 
able return  upon  the  investment,  and  the  opportunity  of 
amortizing  their  funded  debt  out  of  earnings  is  no  longer  open 
to  them.  None  of  the  railroads,  for  instance,  can  attempt 
amortization,  except  in  the  case  of  equipment  obligations. 
There  are  but  few  corporations  of  other  classes  which  are 
placed  fortunately  enough  to  attempt  amortization. 

Retiring  an  issue  of  bonds  in  its  entirety  from  the  pro- 
ceeds of  another  bond  issue  merely  converts  the  debt  into 
another  class;  it  does  not  amortize  the  debt.  Similarly,  to 
retire  a  bond  issue  from  the  proceeds  of  additional  stock 
changes  only  the  form  of  capital ;  the  debt  is  discharged,  but 
not  as  the  result  of  anticipatory  provisions  which  have  been 
currently  appropriating  earnings  or  other  funds  for  that  pur- 
pose. In  neither  of  the  above  cases  is  the  total  capital  liability, 
so  to  speak,  (i.e.,  the  total  of  capital  stock  and  funded  debt  out- 
standing) decreased,  and  the  transactions  represent  refunding 
or  refinancing,  rather  than  amortization. 

To  amortize  a  debt  is  to  reduce  the  outstanding  balance 
periodically  by  redemption,  or  else  to  provide  for  future  re- 
demption by  specific  appropriation  of  earnings  and  other 
funds.  The  two  principal  methods  are  therefore  those  of 
serial  redemption  and  of  sinking  fund  provisions,  discussed  in 
the  following  sections.  Serial  redemption  may  be  provided 
for  by  having  the  bonds  mature  in  series,  but  it  may  also  be 
effected  without  introducing  differences  in  date  of  maturity, 
by  having  the  corporation  reserve  options  of  redemption  and 


238 


FUNDED   DEBT 


call,  and  then  carry  out  a  fixed  program  of  annual  redemption. 

The  provisions  for  amortization  may  have  been  made  by 
the  stockholders  as  a  matter  of  choice,  or  they  may  have  been 
imposed  as  a  condition  by  the  prospective  investors  in  the 
bonds.  If  amortization  has  been  required  by  the  creditors, 
their  evident  purpose  was  that  of  gradually  reducing  the  debt 
so  as  to  maintain  or  enhance  the  security  for  the  payment  of 
the  debt  as  a  whole.  Usually  there  is  no  requirement  that 
amortization  be  made  out  of  earnings,  and  the  demands  of 
these  creditors  will  be  fully  satisfied  whether  amortization  is 
effected  through  the  appropriation  of  earnings,  or  the  proceeds 
of  capital  stock  issues  or  of  a  junior  issue  of  bonds. 

Where  amortization  of  funded  debt  is  provided  for  at  the 
instance  of  stockholders,  the  debt  cannot  be  thought  of  as  con- 
stituting loan  capital ;  it  is  rather  a  kind  of  temporary  financial 
assistance  extended  to  the  stockholders  who  intend  to  wipe  out 
the  debt  through  the  income  produced  by  the  enterprise. 
They  intend  to  defer  the  taking  of  a  part  of  the  profits  in 
order  that  the  debt  may  be  lifted.  Where  the  bonds  are  re- 
deemed out  of  the  proceeds  of  moneys  borrowed  temporarily, 
the  situation  is  much  the  same  as  if  they  had  been  redeemed 
forthwith  out  of  the  revenues,  since  the  temporary  indebted- 
ness must  eventually  be  wiped  out  through  that  channel. 

Given  an  enterprise  so  situated  as  to  produce  earnings 
sufficient  to  allow  for  amortizing  the  debt,  a  great  many  con- 
siderations may  prompt  the  stockholders  to  provide  for  volun- 
tary amortization.  Earnings  applied  to  the  discharge  of 
funded  debt,  in  decreasing  the  debt,  increase  the  free  assets 
and  correspondingly  the  value  of  the  shares;  hence,  the  profit 
of  the  stockholder  is  the  same  as  if  an  equal  amount  instead 
of  being  applied  to  the  amortization  of  the  debt  had  been 
distributed  as  dividends;  in  fact,  it  is  more  to  the  stock- 
holders' advantage  since  with  the  extinguishing  of  the  debt 
the  amounts  theretofore  applied  to  interest  charges  will  go  to 
swell  the  dividends  fund.    There  is  this  temporary  disadvan- 


REFUNDING  AND  REDEMPTION  OF  BONDS 


239 


tage,  of  course,  that  the  increased  share  value  is  not  as  readily 
available  as  dividends  would  be.  Then,  again,  the  destruction 
of  the  lien  of  the  debt  upon  the  property  increases  the  security 
of  the  stockholders'  investment  by  eliminating  the  contingency 
of  control  passing  out  of  their  hands  through  foreclosure  at  a 
time  when  for  one  reason  or  another  the  interest  could  not 
be  paid. 

§  123.     (i)  Serial  Bonds 

Serial  bonds  are  those  of  an  issue  so  arranged  as  to  mature 
a  certain  number  of  them  at  stated  intervals,  i.e.,  serially.  In 
contradistinction,  bonds  maturing  all  at  one  time  are  some- 
times called  "straight"  bonds.  Serial  bonds  are  most  often 
used  in  equipment  obligations  as  before  described.  Outside 
of  the  realm  of  private  corporations,  the  funded  debt  of 
municipalities  issued  for  water- works,  gas  and  electric  plants, 
etc.,  is  very  often  arranged  in  serial  maturities.  The  bonds 
maturing  annually  or  semiannually  are  retired  and  the  total 
debt  is  thereby  reduced,  the  whole  indebtedness  being  wiped 
out  when  the  last  bond  in  the  series  matures  and  is  retired. 
In  serial  issues  no  premium  accompanies  the  retirement  of  the 
matured  bonds,  as  in  the  case  of  redeemable  bonds  retired  be- 
fore maturity. 

In  a  serial  issue  the  bonds  themselves  show  the  date  of 
their  respective  maturities,  hence  the  purchaser  knows  exactly 
the  term  of  the  bonds  and  is  subject  to  no  such  uncertainty  as 
accompanies  redeemable  bonds.  An  investor  may  therefore 
choose  those  having  a  long  or  short  life  according  to  his  own 
needs.  Serial  retirement,  however,  may  have  the  effect  of 
bringing  about  unequal  market  values  of  bonds  of  the  same 
issue,  due  to  the  varying  term  in  years. 

§  124.     (2)  Sinking  Funds 

A  sinking  fund  is  the  accumulation  of  periodic  appropria- 
tions so  arranged  in  amount  and  investment  as  to  have  them, 


240 


FUNDED    DEBT 


together  with  their  interest  accruals,  equal  a  given  sum  at  a 
future  date  when  the  entire  accumulation  is  to  be  applied  to  a 
predetermined  purpose. 

An  approved  method  for  the  operation  of  a  sinking  fund 
built  up  out  of  revenue  is  as  follows:  The  annual  or  semi- 
annual instalment  is  charged  against  the  gross  income  for  the 
period,  or  against  the  corporate  surplus,  as  the  case  may  be, 
through  an  account  entitled,  say,  "Sinking  Fund  Accruals" ; 
the  corresponding  credit  is  to  a  balance  sheet  account  appear- 
ing on  the  liabilities  side  as  "Sinking  Fund  Reserve."  This 
accounts  for  the  appropriation  of  income  or  surplus  but  leaves 
the  appropriated  amount  among  the  general  assets.  If  it  is  de- 
sired to  segregate  the  cash  or  other  property  into  a  specific 
fund,  further  entries  are  necessary.  The  asset  set  aside  in  the 
first  instance  is  usually  a  sum  of  money  which  will  be  in- 
Vested  later  in  other  property.  To  carry  the  transaction 
through  the  accounts,  therefore,  as  each  appropriation  is 
debited  against  income  or  surplus  and  credited  to  "Sinking 
Fund  Reserves,"  the  same  amount  will  be  credited  to  account 
"Cash"  and  debited  to  account  "Sinking  Funds  Uninvested." 
In  this  last-named  account  the  fund  is  accumulated  pending 
investment,  and  when  any  part  of  the  moneys  held  therein  is 
invested  in  other  properties,  the  amount  of  the  investment  will 
be  transferred  to  the  debit  of  an  account  "Sinking  Fund  In- 
vestments," having  been  concurrently  credited  against  the  ac- 
count "Sinking  Funds  Uninvested."  The  income  accruing 
from  the  investments  in  the  sinking  fund  will  go  to  increase 
the  fund  awaiting  investment,  unless  there  is  an  understanding 
to  the  effect  that  the  income  shall  go  to  the  corporation  and 
that  only  the  fixed  appropriations  to  be  made  by  the  company 
will  be  looked  to  for  the  accumulation  of  the  sinking  fund. 
The  most  usual  situation  is  that  the  increment  of  the  fund 
constitutes  accretions  to  it.  The  corporation  will  take  the  in- 
come from  the  investments  into  its  own  general  income  ac- 
count as  interest  or  dividends  received,  and  then  transfer  the 


REFUNDING   AND    REDEMPTION    OF    BONDS       24I 

amount  thereof  to  the  debit  of  "Sinking  Funds  Uninvested," 
having  charged  the  amount  out  of  income  or  surplus  through 
the  same  accounts  as  were  used  in  accounting  for  the  regular 
appropriations.  When  the  bonds  in  respect  of  which  the 
sinking  fund  was  created  fall  due,  the  investments  are  sold 
and  the  proceeds  applied  to  the  extinction  of  the  debt;  the 
investment  account  is  credited  and  cash  account  debited  for 
the  liquidation  of  investments,  while  for  the  payment  of  the 
debt  "Cash"  is  credited  and  "Funded  Debt"  debited.  The 
sinking  fund  reserve  remains  undisturbed  until  its  balance  is 
transferred  to  surplus  account  or  appropriated  to  some  other 
purpose. 

Whether  the  sinking  fund  appropriations  shall  be  charged 
against  gross  income  and  before  arriving  at  the  net  income  to 
be  transferred-  to  Profit  and  Loss  account,  or  whether  they 
shall  be  charged  directly  against  Profit  and  Loss  account,  is 
a  debated  question.  Some  accountants  distinguish  between 
sinking  fund  appropriations  made  pursuant  to  mortgage  pro- 
visions and  those  made  from  the  choice  of  the  corporation. 
They  would  charge  the  former  against  gross  income  in  much 
the  same  manner  as  interest,  but  would  charge  the  latter 
against  the  Profit  and  Loss  account.  The  theory  is  that  in  the 
former  case  the  appropriations  represent  contractual  charges 
presumably  relating  to  the  cost  of  acquiring  the  use  of  money, 
while  in  the  second  case  they  merely  earmark  certain  portions 
of  surplus  set  aside  by  the  stockholders,  and  designated  for  a 
particular  purpose  the  accomplishment  of  which  will  release 
the  accumulated  appropriations  to  the  benefit  of  the  stock- 
holders. This  method  is  the  one  prescribed  by  most  of  the 
state  commissions  and  the  Interstate  Commerce  Commission. 
On  the  other  hand,  there  are  accountants  who  contend  that 
since  the  operation  of  a  sinking  fund  accumulated  out  of  in- 
come is  ultimately  to  increase  the  stockholders'  equity  by  the 
amount  of  the  debt  discharged,  the  several  appropriations 
thereto,  whether  made  pursuant  to  contractual  requirements  or 


242 


FUNDED    DEBT 


voluntarily,  should  be  recorded  as  profits  accruing  to  the  stock- 
holders even  though  their  immediate  disposition  is  subject  to 
limitations.  They  hold  that  to  charge  these  appropriations 
against  gross  income  before  arriving  at  the  net  income  is  to 
understate  the  actual  profit  for  the  period.  The  contention 
is  not  without  merit.  Under  its  application  the  appropriations 
would  be  charged  against  the  Profit  and  Loss  account  to  rep- 
resent what  they  in  fact  are — profits  of  the  corporation  with- 
held from  dividend  distribution  either  voluntarily  by  the  cor- 
poration or  because  of  contract  requirements,  pending  the 
accomplishment  of  a  certain  purpose,  to  wit,  the  reduction  of 
the  debt.  As  against  its  logic,  however,  there  must  be  weighed 
the  desirability  of  having  all  the  fixed  financial  responsibilities 
of  the  corporation  taken  care  of  before  the  income  for  the 
period  is  recorded;  this  makes  it  eminently  proper  to  give  due 
consideration  to  the  purpose  of  the  sinking  fund  in  adopting  an 
accounting  rule  and  practice. 

The  foregoing  paragraph  has  dealt  solely  with  sinking 
funds  accumulated  out  of  income.  The  effect  of  the  methods 
described  is  that  of  setting  aside  in  the  first  instance  a  part  of 
the  earnings.  There  are  some  accountants  who  claim  that  in 
the  absence  of  specific  provisions  of  the  mortgage  requiring 
accruals  to  be  charged  against  income,  the  corporation  is  at 
liberty  to  make  the  accumulation  from  any  source  whatever, 
even  from  borrowed  moneys  or  the  proceeds  of  stock  issues. 
Those  who  make  this  claim  will  not  record  any  setting  aside  of 
earnings  or  surplus  but  will  simply  set  aside  certain  of  the 
assets  to  constitute  a  separate  fund.  The  entries  affect  only 
balance  sheet  accounts,  shifting  assets;  there  will  be  no  "Sink- 
ing Fund  Accruals"  account  in  the  income  statement  and  no 
"Sinking  Fund  Reserve"  on  the  balance  sheet.  It  is  difficult  to 
justify  the  propriety  of  such  a  method;  if  the  correct  theory 
and  legitimate  purposes  of  a  bona-fide  sinking  fund  are  to  be 
carried  out,  the  transaction  should  be  handled  through  the 
general  income  account  of  the  corporation. 


REFUNDING  AND  REDEMPTION  OF  BONDS 


243 


§  125.  (3)  Effect  of  Serial  Maturities  or  Sinking  Fund 
Accruals 

The  effect  upon  the  debt  of  serial  maturities  or  sinking 
fund  provisions  is  substantially  the  same.  It  is  very  much 
as  if  a  man  owing  a  mortgage  debt  agrees  with  the  mortgagee 
to  pay  him  $100  on  the  principal  on  each  interest  date,  or, 
failing  to  make  the  agreement,  puts  away  in  a  savings  fund 
$100  upon  each  interest  date,  figuring  that  he  will  thus  have 
saved  enough  by  the  date  of  maturity  of  the  mortgage  to  pay 
it  up.    In  other  words,  he  is  amortizing  the  debt. 

In  the  case  of  equipment  obligations  we  have  already  noted 
how  serial  redemption  increases  the  equity  of  the  bondholder. 
In  precisely  the  same  manner  sinking  fund  accruals  enhance 
the  equity  of  the  bondholder  and  for  that  reason  prospective 
bond  purchasers  have  often  bargained  that  a  sinking  fund  be 
provided  to  supplement  the  security.  For  instance,  in  the  early 
years  of  electric  railway  operations,  with  the  history  of  the 
change  from  animal  traction  to  cable  still  fresh  in  the  minds 
of  the  investors,  the  future  of  companies  engaged  in  these 
operations  seemed  more  or  less  speculative,  so  much  so  that 
provisions  for  the  accumulation  of  funds  to  pay  off  the 
mortgage  upon  maturity  were  often  deemed  prudent  and 
desirable. 

In  further  reference  to  equipment  obligations,  the  relation 
between  serial  redemption  and  accruing  depreciation  was  also 
pointed  out,  the  underlying  theory  being  stated  as  that  of 
amortizing  the  debt  along  with  the  decrease  in  the  value  of 
the  asset  standing  back  of  the  debt;  in  other  words,  of  making 
the  property  pay  for  itself.  The  same  theory  is  applicable  to 
the  amortization  of  debt  by  the  sinking  fund  method,  hence  it 
has  sometimes  been  thought  to  constitute  only  another  form 
of  providing  against  depreciation.  Under  correct  depreciation 
accounting,  one  aim  is  to  maintain  the  integrity  of  the  bond- 
holders' security  by  having  on  hand  an  amount  sufficient  to 
make  good  the  reduction  in  capital  account  so  as  to  maintain 


244 


FUNDED   DEBT 


the  same  proportionate  relationship  between  the  value  of  the 
property  and  the  outstanding  debt  as  existed  when  the  bonds 
were  first  issued.  So  far  as  protection  of  the  bondholder  is 
concerned,  therefore,  the  aims  of  the  two  methods  are  very 
much  the  same ;  in  fact,  they  may  be  said  to  be  identical  to  the 
extent  that  the  one  would  make  the  other  dispensable.  A 
differentiation,  if  one  must  be  found,  may  lie  in  this,  that  while 
depreciation  reserve  provisions  assure  against  loss  in  the  value 
of  the  property  itself  through  depreciation  alone,  sinking  fund 
provisions  assure  against  loss  in  the  undertaking  as  a  whole. 
In  the  instance  of  a  natural  gas  corporation,  for  instance,  a 
depreciation  reserve  based  upon  the  physical  property  in  use 
would  be  a  very-  inadequate  measure  of  protection,  while  de- 
preciation to  provide  for  the  exhaustion  of  the  wells  could  be 
little  more  than  pure  estimate;  an  adequate  measure  of  security 
could  be  afforded,  however,  by  provisions  looking  to  the 
amortization  of  the  debt. 

It  should  also  be  noted  that  depreciation  is  accounted  for 
in  operating  expenses,  while  sinking  fund  appropriations  are 
deductions  from  the  gross  income  or  surplus.  In  relation  to 
the  comparison  of  results  produced  by  depreciation  accounting 
and  sinking  fund  provisions,  it  needs  to  be  further  noted  that 
in  the  latter  case  there  is  always  deliberate  purpose  to  have  the 
accumulation  progress  at  a  more  rapid  rate  than  the  loss  in 
value,  hence  the  equity  is  constantly  increasing.  In  deprecia- 
tion accounting,  however,  the  current  charges  are  intended  to 
equal,  neither  exceeding  nor  falling  under,  the  current  loss  in 
value,  so  that  the  equity  remains  constant.  Very  often,  of 
course,  no  relation  whatever  will  be  found  between  a  bond 
issue  and  specific  assets,  so  that  the  sinking  fund  provisions 
cannot  even  be  assumed  to  have  been  based  in  any  way  upon 
the  measure  of  the  current  depreciation  of  the  assets;  in  fact, 
the  assets  securing  the  issue,  as  a  whole,  may  actually  appreci- 
ate in  value. 

The   fundamental  distinction,  of  course,  is  that  sinking 


REFUNDING   AND    REDEMPTION    OF   BONDS 


245 


funds  are  required  for  the  benefit  of  the  creditor,  while  de- 
preciation accounts  are  for  the  benefit  of  the  business  itself. 

In  a  serial  issue,  certain  of  the  bonds  mature  periodically, 
and  as  they  mature  they  must  be  retired.  When  the  term  is 
absolute,  failure  to  meet  payment  of  a  matured  bond  con- 
stitutes default  of  the  entire  outstanding  issue  and  subjects  the 
property  to  foreclosure,  hence  great  efforts  will  be  made  by 
the  debtor  corporation  to  meet  each  maturity.  Serial  redemp- 
tion is  therefore  the  most  certain  method  where  the  debt  must 
be  amortized,  as  in  the  case  of  equipment  obligations  or  bonds 
issued  against  natural  resources,  e.g.,  those  of  a  natural  gas 
corporation.  It  is  true  of  serial  bonds,  however,  that  more 
often  than  in  the  case  of  sinking  fund  appropriations  the  re- 
tirements will  be  effected  out  of  the  proceeds  of  moneys  bor- 
rowed or  acquired  from  sources  other  than  the  current  income. 

§  126.     (4)  Equalizing  Annual  Burden  of  Amortization 

In  every  problem  of  amortization  the  most  important 
factor  is  the  equitable  distribution  of  its  burden  throughout 
the  period  of  amortization.  The  burden  of  a  debt  which  is 
not  intended  to  run  in  perpetuity  consists  of  the  obligation  to 
pay  interest  and  to  meet  the  maturity  of  the  principal.  The 
purpose  of  amortizing  the  debt  is  to  distribute  the  aggregate 
burden  over  the  life  of  each  debt.  Serial  maturities  are  gen- 
erally arranged  in  equal  annual  or  semiannual  maturities. 
This  evenly  distributes  the  principal  but  not  the  interest  of  the 
debt,  hence  the  aggregate  burden  is  heaviest  in  the  earliest 
years  and  grows  lighter  as  the  period  of  amortization  ad- 
vances; that  is  to  say,  in  many  cases  this  places  the  heaviest 
burden  at  the  point  where  the  corporation  is  least  able  to 
carry  it,  to  wit,  when  the  enterprise  is  new  and  before  its  full 
earning  capacity  has  become  developed.  To  remedy  this  de- 
fect the  serial  maturities  may  be  so  arranged  that  the  sum  of 
annual  interest  charges  plus  the  maturities  will  be  equal  in 
each  year ;  as  the  interest  decreases  each  year  with  the  dimin- 


246  FUNDED   DEBT 

ishing  principal,  the  amounts  maturing  will  be  correspondingly 
increased.  Issues  so  arranged  are  spoken  of  as  equal  instal- 
ment bonds.  Through  the  sinking  fund  method  the  burden 
may  be  still  more  evenly  approximated,  since  calculations 
may  be  exactly  carried  out,  and  the  annual  or  semiannual  ap- 
propriations do  not  need  to  conform  to  the  par  value  of  matur- 
ing bonds. 

§  127.     (5)  Sinking  Fund  Investments 

The  operation  of  a  sinking  fund  requires  the  actual  setting 
aside  of  funds,  and  the  disposition  of  that  fund  during  the 
period  of  accumulation  becomes  very  important.  The  cor- 
poration may  do  one  of  four  things:  it  may  hold  the  fund  in 
cash,  uninvested ;  it  may  invest  the  fund  in  purchasing  bonds 
of  the  issue  to  which  the  sinking  fund  relates  or  of  another 
of  its  own  issues;  it  may  invest  the  fund  in  securities  other 
than  its  own ;  or  it  may  invest  in  its  own  operations.  The 
provisions  of  the  mortgage  itself  may  be  controlling  as  to 
the  disposition  of  the  fund. 

The  accumulation  of  a  cash  fund  is  practically  out  of  the 
question,  since  it  would  be  the  worst  policy  or  practice  to 
allow  large  cash  reserves  to  accumulate  and  remain  idle,  earn- 
ing at  best  but  a  very  low  rate  of  interest. 

The  second  option  open  to  the  corporation  is  that  of  in- 
vesting in  its  own  securities  of  the  identical  issue  to  which  the 
sinking  fund  relates  or  of  another  issue.  In  the  former  in- 
stance the  corporation  is  practically  retiring  the  bond  issue 
serially,  except  that  it  is  not  subject  to  the  demand  of  any 
bondholder  as  it  would  be  to  the  holder  of  a  matured  serial 
bond,  and  it  can  seek  and  await  the  opportunity  of  reacquiring 
its  bonds  upon  the  most  advantageous  terms.  Requirements 
that  the  fund  be  invested  in  purchasing  bonds  of  the  issue  to 
which  it  relates  are  the  most  usual.  The  bonds  so  reacquired 
are  placed  with  the  trustee  under  the  mortgage  and  marked 
"Not  Negotiable."     This  is  undoubtedly  the  most  advantage- 


REFUNDING    AND    REDEMPTION    OF    BONDS       247 

ous  method,  as  it  accomplishes  a  number  of  desirable  purposes. 
It  actually  retires  the  debt  gradually;  it  obviates  the  exercise 
of  judgment  in  selecting  a  proper  investment;  it  saves  the  cor- 
poration possible  loss  in  unwise  investments;  by  making  the 
corporation  a  constant  bidder  for  its  own  bonds,  it  helps  to 
maintain  the  market  values  of  the  issue,  indirectly  promoting 
the  credit  of  the  corporation/ 

It  is  somewhat  of  a  misnomer  to  designate  as  "invest- 
ments" the  bonds  so  reacquired,  since  the  term  carries  a  col- 
lateral implication  that  there  is  somewhere  an  outstanding 
obligation  creating  a  claim  sufficient  to  constitute  an  invest- 
ment ;  however,  many  corporations  insist  upon  considering  the 
full  amount  of  the  issue  as  outstanding  and  include  among  their 
assets  the  value  of  the  reacquired  bonds.  Manifestly  a  cor- 
poration cannot,  any  more  than  an  individual,  owe  to  itself; 
even  the  law  with  its  many  fictions  could  never  recognize  a 
private  resolution  as  creating  any  right  or  claim  accruing  to 
the  benefit  of  someone  else.  It  would  be  far  better  for  the 
corporation  to  show  as  its  funded  indebtedness  only  the  net 
amount  after  deducting  the  par  value  of  the  reacquired  bonds, 
making  the  necessary  adjustments  between  the  par  and  the 
purchase  price  through  its  Profit  and  Loss  or  Sinking  Fund 
Accruals  account.  The  accounting  requirements  of  many 
commissions  require  such  treatment.  Where  the  corporation 
invests  in  its  own  bonds  of  an  issue  other  than  that  to  which 
the  sinking  fund  relates  and  which  it  may  reissue,  the  securi- 
ties perhaps  cannot  be  logically  considered  as  finally  retired 
and  the  corporation  may  be  warranted  in  including  them 
among  the  investments,  but  it  should  always  show  separately 
holdings  of  its  own  securities. 

The  third  option  enables  the  corporation  to  invest  the  fund 
in  securities  other  than  those  issued  by  itself.     Investments 


*  It  may  be  asserted  that  an  artificial  demand  may  be  created  which  will  result  in 
inflation  of  market  values.  To  produce  that  effect  the  corporation  must  be  in  a  position 
to  buy  back  large  numbers  of  bonds  and  to  pay  the  higher  prices  demanded;  it  will, 
therefore,  be  anxious  to  restrict  its  purchases  if  the  price  is  unreasonable,  and  the  situa- 
tion win  usually  correct  itself. 


248  FUNDED   DEBT 

thus  made,  as  also  the  cash  in  the  fund  awaiting  investment, 
are  always  subject  to  the  specific  lien  of  the  mortgage  of  which 
the  sinking  fund  provisions,  if  the  fund  is  a  contractual  one, 
are  a  part.  Substantial  objections  can  be  raised  against  this 
disposition  of  sinking  fund,  both  from  the  standpoint  of  the 
bond  and  stock  holders,  and  from  that  of  general  public  policy. 
The  safety  of  the  fund  is  here  made  dependent  upon  the 
prudence  and  wisdom  exercised  in  the  choice  of  investments; 
the  risk  of  the  investment  is  added  to  the  risk  of  the  corpora- 
tion's own  enterprise.  Then,  again,  a  serious  difficulty  arises 
in  properly  correlating  the  income  derived  from  the  invest- 
ment to  the  interest  upon  the  bonds  to  which  the  fund  relates ; 
if  the  corporation  pays  6  per  cent  on  its  own  bonds  it  must  get 
at  least  as  much  upon  the  investments  of  the  sinking  fund  if  it 
is  to  avoid  actual  loss.  Moreover,  where  the  fund  is  to  be  in- 
vested in  outside  securities,  it  is  not  possible  to  make  correct 
computation  in  advance,  since  it  is  not  possible  to  predict  at 
what  price  the  securities  will  be  purchased,  when  they  may  be 
acquired,  and  what  the  net  yield  will  be.  Again,  when  the 
bonds  mature  and  the  sinking  fund  is  about  to  be  applied  to 
the  discharge  of  the  debt,  it  may  not  be  easy  to  realize  ad- 
vantageously upon  the  investments  of  the  fund.  A  situation 
which  would  be  condemned  by  general  public  policy  might 
arise  if  the  sinking  fund  were  of  a  large  amount,  causing  the 
investment  operations  of  the  company  to  become  relatively  of 
as  great  importance  as  its  public  utility  operations. 

Upon  the  assumption  that  the  corporation  in  its  own 
operations  can  earn  more  than  the  rate  of  income  derivable 
from  investments  either  in  securities  of  other  corporations  or 
in  its  own  bonds,  it  is  to  the  greatest  advantage  of  all  parties 
concerned  to  have  the  company  use  the  fund  in  extending  its 
own  enterprise.  The  fund  will  then  be  distributed  among  the 
general  assets  of  the  corporation  and  will  not  be  separately 
identified,  its  accumulation  being  indicated  only  by  the  reserve 
account  which  will  record  the  current  appropriations.     If  the 


REFUNDING   AND    REDEAIPTION    OF    BONDS       249 

provisions  for  amortization  of  the  debt  are  voluntary  on  the 
part  of  the  corporation,  this  method  is  the  most  satisfactory, 
but  if  they  are  contractual,  the  setting  aside  of  an  actual  fund 
is  usually  necessary. 

Throughout  this  entire  discussion  the  implication  has  been 
that  the  corporation  has  complete  control  over  the  sinking 
fund  and  its  investments.  Practically  in  all  instances  where 
the  fund  is  a  contractual  one,  the  trustee  under  the  mortgage 
is  also  the  trustee  of  the  fund.  Ostensibly  it  is  the  trustee 
who  makes  the  investment;  all  securities  are  placed  in  his  care, 
and  all  payments  on  account  of  the  fund  are  made  to  him.  He 
may  well  be  considered,  however,  as  the  agent  of  the  corpora- 
tion, since  his  expenses  are  the  expenses  of  the  corpora- 
tion and  his  investments  are  the  investments  of  the  cor- 
poration, which  remains  the  beneficial  owner.  Some  people 
try  to  draw  a  very  sharp  distinction  between  the  trustee  and 
the  corporation  in  this  respect;  and  where  the  trustee  holds 
bonds  of  the  identical  issue  to  which  the  fund  relates  they 
claim  that  it  is  the  trustee  who  has  purchased  and  continues 
to  hold  the  bonds  so  that  the  corporation  will  be  required  to 
recognize  them  as  valid  outstanding  claims.  But  since  the 
trustee  will  hold  these  bonds  until  the  fund  has  served  its 
purpose  of  redeeming  the  entire  issue,  and  he  will  have  no 
authority  ever  again  to  place  them  in  other  hands,  the  dis- 
tinction would  seem  to  be  drawn  too  finely  and  to  be  unneces- 
sary for  any  legitimate  purpose  of  corporate  finance  or  ac- 
counting. 

§  128.  (6)  Extent  to  Which  Sinking  Funds  Are  Now  Used 
Sinking  funds  are  not  as  common  as  they  used  to  be;  it 
has  become  generally  recognized  that  there  are  better  ways 
of  safeguarding  the  security  holder.  With  the  advent  of 
public  regulation  and  the  growing  size  of  corporations,  it  is 
becoming  more  and  more  important  that  capital,  whether  loan 
or  share,  be  treated  strictly  as  capital.     Moreover,  the  rate 


250 


FUNDED    DEBT 


of  return  allowed  does  not  contemplate  instalment  payments 
upon  the  principal  of  the  capital. 

"Twenty  years  ago  sinking  funds  were  considered  a  usual 
and  proper  safeguard  of  railway  loans,  but  the  experience  of 
the  lean  years  following  the  panic  of  1893  destroyed  faith  in 
their  efficacy,  for  about  25  per  cent  of  all  railway  obligations 
so  secured,  defaulted.  It  came  to  be  realized  that  sinking  fund 
accounts  could  be  subject  to  manipulative  tactics  which  would 
render  them  a  source  of  expense  and  loss  of  credit  rather 
than  of  income  and  confidence.  For  instance,  where  earnings 
did  not  admit  payments  to  the  sinking  funds  (which  In  ac- 
counting are  a  charge  prior  to  interest  payments),  new  bonds 
were  issued  to  raise  the  money  necessary  for  sinking  fund 
payments,  so  the  total  debt  was  increased  rather  than  de- 
creased, with  consequent  loss  of  net  earning  power  and  credit. 
Thus  it  was  realized  that  the  best  reinforcement  of  an  obliga- 
tion was  obtained  by  putting  the  surplusage  back  into  the 
property,  and  by  refunding  bond  issues  as  they  matured,  on 
the  strength  of  an  increased  credit,  and  therefore  at  a  lower 
rate  of  interest. 

"It  is  evident,  how^ever,  that  this  fiscal  policy  will  not  al- 
ways be  best  for  small  companies,  or  for  companies  owning 
properties  which  must  be  depleted  to  produce  revenue  (wast- 
ing assets).  It  is  imperative,  for  instance,  that  the  out- 
standing obligations  of  a  coal  company  should  lessen,  as  the 
supply  of  its  marketable  product  lessens."  ^ 

^Lawrence  Chamberlain:  "The  Principles  of  Bond  Investments." 


CHAPTER   XII 

RELATION    OF    BONDS    TO    STOCK 

§  129.     Importance  of  Proper  Proportion  Between  Stocks  and 
Bonds 

The  proportion  of  the  total  capital  to  be  represented  by- 
bonds  and  that  to  be  represented  by  stock  is  often  one  of  the 
most  difficult  questions  in  the  organization  of  a  corporation, 
or  in  subsequent  modifications  of  its  financial  status.  In  some 
few  happy  instances  this  proposition  offers  no  problem  at  all ; 
the  incorporators  have  estimated  carefully  the  sum  necessary 
for  the  enterprise  and  are  in  a  position  to  approximate  the 
return  that  will  be  produced  upon  the  total  sum  to  be  invested. 
They  have  ascertained  also  the  total  amount  of  capital  which 
they  are  themselves  able  or  willing  to  commit,  so  that  the 
difference  between  that  and  the  sum  required  for  the  enter- 
prise is  the  amount  to  be  procured  through  the  issue  of  bonds. 
In  by  far  the  greater  number  of  instances,  however,  the  ques- 
tion is  a  very  complicated  one  and  the  answer  thereto  must  be 
evolved  out  of  considerations  of  market  conditions,  the  cur- 
rent demand  for  investment  in  stocks  or  in  bonds,  the  rate  of 
discount  and  of  interest,  the  credit  of  the  incorporators  and 
the  repute  of  the  enterprise,  the  prospect  for  earnings,  etc. 
All  of  these  matters  demand  serious  and  careful  thought;  a 
proper  admeasurement  of  the  relative  force  and  significance  of 
each  of  them  becomes  the  specialized  business  of  the  banker. 

§  130.     (i)  Earlier  Tendency  Toward  Greater  Proportion  of 
Bonds 
In  the  public  service  corporations  the  tendency  has  been  to 
maintain  and  increase  the  proportion  of  bonds  to  stock.    This 

251 


252 


FUNDED   DEBT 


has  resulted  In  the  now  insistent  public  complaint  that  rail- 
roads have  been  built  out  of  the  proceeds  of  bond  issues;  that 
bonds  represent  the  true  capitalization  and  the  stock  repre- 
sents the  "water."  To  bear  out  this  complaint  "physical 
valuation"  of  railroad  properties  has  been  widely  demanded 
and  is  now  under  way.  The  complaint  may  be  well  founded 
in  some  cases,  but  it  certainly  is  not  true  of  all  railroads  and 
still  less  true  of  other  public  utilities  as  a  whole.  The  Inter- 
state Commerce  Commission  has  reported  the  aggregate  capi- 
talization of  all  railroads  in  the  United  States  as  of  June  30, 
191 5,  to  be  approximately  $19,700,000,000,  of  which  about 
56  per  cent  or  $11,100,000,000  was  represented  by  bonds  and 
other  certificates  of  indebtedness,  and  44  per  cent  or  $8,600,- 
000,000  by  stocks. 

This  tendency  has  been  ascribed  to  a  disinclination  on  the 
part  of  stockholders  to  put  their  own  money  into  these  enter- 
prises, relying  instead  upon  the  proceeds  of  bond  issues.  The 
Committee  on  Capitalization  of  the  National  Association  of 
Railway  Commissions  reported  in  1913:^ 

"If  we  should  attempt  to  name  the  one  factor  which  has 
been  most  productive  of  financial  troubles  and  which  has  con- 
tributed most  to  the  necessity  for  regulation  we  would  have 
no  hesitancy  in  saying  that  it  has  been  the  design  of  the  men 
promoting  and  controlling  utilities  to  make  somebody  take 
the  risks  and  they  themselves  take  the  chances  of  profit,  and 
not  even  today  when  utilities  are  supposed  to  be  very  much 
reformed  do  we  find  stockholders  adverse  to  getting  their 
stock  for  nothing  and  taking  the  chance  that  value  may  be 
placed  behind  it  out  of  the  rates  which  the  utility  will  be  per- 
mitted to  earn.  The  building  of  utility  enterprises  entirely 
from  borrowed  money  is  so  illogical  that  it  would  seem  not 
worthy  of  discussion  were  it  not  for  the  fact  that  it  not  only 
has  been  the  practice  in  the  past  but  it  is  a  practice  too  prev- 
alent today,  and  if  it  is  illogical  and  unsound  financing  to 

*  Published  in  proceedings  of  the  Convention,  page  180. 


RELATION    OF   BONDS    TO    STOCK 


253 


borrow  all  the  money  which  goes  into  a  utility  originally,  for 
the  same  reason  it  is  illogical  and  unsound  financing  to  borrow 
more  money  to  make  extensions  or  improvements  for  the 
utility  that  has  originally  been  so  constructed." 

The  Railroad  Securities  Commission  in  its  report  had 
also  referred  to  the  same  subject  in  the  following  words: 

"One  of  these  evils"  (resulting  from  the  practice  above 
described)  "was  that  the  bondholders  were  at  times  deluded 
into  the  belief  that  there  was  a  security  behind  their  bonds 
which  did  not  exist,  and  that  the  railroad  company  was 
mortgaging  a  piece  of  property  when  it  was  only  capitalizing 
an  expectation.  They  thus  entrusted  the  control  of  their 
money  to  men  who  had  comparatively  little  at  stake.  If  a 
profit  was  made,  the  promoters  could  appropriate  it;  if  money 
was  lost,  the  loss  fell  on  the  bondholders.  Roads  built  largely 
with  borrowed  capital  at  the  beginning  have  been  prevented 
from  subsequently  obtaining  the  credit  which  they  might 
otherwise  command.  They  have  therefore  been  less  able  to 
give  to  the  shippers  or  to  the  travelers  the  facilities  which  are 
requisite  no  less  for  the  convenience  and  safety  of  the  public, 
than  for  the  profitable  utilization  of  the  railroad  itself.  To 
the  extent  that  we  lessen  debt,  we  shall  increase  the  powers 
of  the  roads  to  raise  money  when  the  public  needs  added  facili- 
ties and  shall  at  the  same  time  reduce  the  chance  of  default 
and  lessen  the  severity  of  commercial  crises.' 

"The  Government  cannot  protect  the  investors  against  the 
consequences  of  their  unwisdom  in  buying  unprofitable  bonds, 
any  more  than  it  can  protect  the  consumers  against  the  conse- 
quences of  their  unwisdom  in  eating  indigestible  food.  Unless 
we  are  prepared  to  have  government  guarantees  of  interest  on 
railroad  investments — a  most  questionable  proposal — the  only 
way  in  which  we  can  standardize  railroad  mortgages  is  the 
one  which  we  use  with  savings  banks  mortgages.  We  can  in- 
sist upon  double  security.    We  can  say  that  at  least  half  the 

'  Page  17  of  report. 


254 


FUNDED   DEBT 


capital  of  a  railroad  must  be  subscribed  by  stockholders,  and 
that  no  more  than  half  may  be  raised  by  l)orrowing — a  diffi- 
cult requirement  under  existing  conditions."  ^ 

If  error  has  been  made  in  unduly  expanding  the  proportion 
of  bond  to  stock  issues,  it  is  not  just  to  lay  the  entire  blame 
on  the  promoters  and  managers  of  corporations  whose  capital- 
izations indicate  such  a  disparity;  much  less  is  it  fair  to  im- 
pute to  these  men  fraudulent  and  corrupt  motives.  On  the 
contrary,  most  of  the  men  who  have  projected  and  developed 
epoch-making  ideas  and  enterprises  have  been  men  of  sterling 
character  and  unquestioned  motive;  men  who  have  deserved 
far  better  treatment  at  the  hands  of  the  communities  whom 
they  have  served  than  that  which  has  been  accorded  them. 
Not  a  little  responsibility  for  the  disproportion  of  bond  to 
stock  issues,  where  it  exists,  should  be  placed  upon  the  in- 
vestors, bankers,  brokers,  and  academicians,  who  seem  to  have 
become  attached  to  forms  rather  than  the  substance  of  securi- 
ties; who  have  taken  and  recommended  securities  for  invest- 
ment because  they  were  called  "bonds"  and  have  discredited 
more  promising  securities  because  they  were  called  "stock," 
all  the  time  being  utterly  ignorant  as  to  the  true  merits  of  the 
securities  offered.  With  an  unquestioning,  unscrutinizing  and 
open  bond  market,  is  it  any  wonder  that  some  promoters  in 
their  anxiety  for  economical  and  quick  financing  should  have 
sought  to  carry  out  their  financing  schemes  largely  through 
bond  issues?  Also  the  great  number  of  existing  accredited 
depositaries  of  bond  investments  encourages  bond  financing. 

§  131.     (2)   Earlier  Tendency  Correcting  Itself 

In  recent  years  the  tendency  has  shifted  in  the  opposite 
direction,  to  wit,  toward  increasing  the  proportion  of  stock 
to  bonds.  The  shift  is  undoubtedly  due  in  no  small  measure 
to  the  increased  protection  afforded  to  stock  issues  through 
public  regulation  which  has  restored  public  confidence  in  the 


^  Page  31   of  report. 


RELATION    OF    BONDS   TO    STOCK 


255 


merits  of  this  class  of  securities.  In  ultimate  theory  there  is 
no  question  that  the  best  method  would  be  to  finance  these 
enterprises  wholly  by  capital  stock  issues ;  there  will  be  ad- 
vantages more  than  offsetting  the  loss  suffered  by  the  stock- 
holders who  might  want  to  "trade  in  the  equity."  It  would 
mean  much  toward  maintaining  corporate  organizations  and 
assuring  their  ultimate  success  on  a  moderate  capitalization. 
The  introduction  of  the  rights  of  mortgage  creditors  in 
corporate  finance  has  resulted  far  too  often  in  needless  and 
premature  financial  reorganization  of  enterprises  which  have 
not  been  able  to  become  immediately  successful,  to  the  great 
loss  of  many  investors  and  of  the  communities  served.  The 
stock  and  bond  capital  of  corporations  which  have  gone 
through  reorganization  has  come  back  to  the  surface  larger 
than  before  default,  with  no  increased  assets  to  offset  the  in- 
crease in  capitalization ;  also,  there  is  placed  upon  the  enter- 
prise the  task  of  earning,  over  and  above  operating  expenses, 
interest  on  an  excessive  loan  capital,  and,  if  possible,  dividends 
on  the  inflated  share  capital,  while  the  conditions  under  which 
that  task  is  to  be  fulfilled  become  more  unfavorable  than  be- 
fore reorganization  because  of  loss  of  credit,  change  of  man- 
agement, curtailment  of  extensions,  etc.  Nevertheless,  the 
place  of  bond  issues  in  the  capitalization  of  corporations  has 
become  definitely  fixed.  In  addition  to  the  extra  profit  ac- 
cruing to  stockholders  through  the  excess  earnings  of  loan 
capital  over  the  amount  paid  in  interest,  these  issues  serve 
the  very  valuable  purpose  of  making  possible  the  extension  of 
a  corporate  enterprise  without  increasing  the  number  of  stock- 
holders ;  otherwise  the  door  might  be  opened  to  admit  a  change 
in  control  and  management,  to  the  disadvantage  of  other  stock- 
holders and  probably  of  the  public  as  well. 

§  132.     (3)  Stockholders'  Investment  Should  Support  Loans 

Of  the  relation  which  ought  to  exist  between  the  contri- 
butions of  stockholders  themselves  and  the  sums  borrowed 


256 


FUNDED   DEBT 


from  holders  of  debt  certificates,  the  PnbHc  Service  Commis- 
sion of  the  Second  District  of  New  York,  said  in  an  early 
case : 

"It  would  seem  to  be  essential  in  order  to  give  credit  to 
any  bond  issue,  that  there  should  be  an  amount  of  actual 
money  invested  by  the  stockholders  in  the  enterprise  suffi- 
cient to  afford  a  moral  guaranty  that  in  the  judgment  of  com- 
petent business  men  it  is  likely  to  prove  commercially  suc- 
cessful and  that  men  of  judgment  and  experience  are  willing 
to  invest  their  capital  in  it  with  no  assurance  of  returns  upon 
that  capital  except  those  coming  from  the  legitimate  profits 
which  may  reasonably  be  anticipated.  It  would  also  seem 
essential  in  the  present  state  of  development  of  railroad  en- 
terprises, that  any  scheme  which  would  receive  the  attention 
of  capitalists  should  present  features  making  it  fairly  certain 
that  the  road  will  pay  its  operating  expenses,  its  taxes,  and  its 
proper  depreciation  charges,  and  leave  a  surplus  above  them 
for  the  payment  of  fixed  charges."  * 

In  a  case  heard  subsequently,  where  it  was  proposed  to  pay 
for  the  extension  of  an  electric  railroad  out  of  the  proceeds 
of  a  bond  issue  alone,  the  Commission  reiterated  the  princi- 
ples expressed  in  the  case  above  cited  and  added: 

"To  the  opinion  thus  expressed  this  Commission  still  ad- 
heres without  the  slightest  abatement  in  any  respect,  except 
that  decisions  of  the  courts  made  since  the  opinion  was  writ- 
ten and  since  the  opinion  was  promulgated  have  placed  in  more 
than  doubt  the  power  of  the  Commission  to  determine  whether 
capitalization  should  be  by  stock  or  bonds  alone  or  a  division  of 
the  same  between  the  two,  against  an  expressed  determination 
of  the  corporation  itself.  If  the  Commission  clearly  and  un- 
equivocally possessed  the  power  which  it  then  supposed  it  had, 
it  would  exercise  the  same  in  this  and  every  other  case  in  ac- 
cordance with  the  principles  above  enunciated. 


*  Rochester,   Corning  and   Elmira  Traction   Co.,   i   P.   S.   C.   Rep.    (and  D.,  N.   Y.) 
166,    188. 


RELATION    OF   BONDS   TO    STOCK 


257 


"The  applicant  insists  upon  issuing  bonds  for  the  entire 

amount If  it  were  clear  under  the   Public  Service 

Commissions  Law,  as  interpreted  by  the  courts,  that  we  had 
power  to  require  a  proper  proportion  of  stock  in  this  case, 
that  power  would  be  unhesitatingly  used  provided  the  facts 
showed  that  an  additional  issue  of  $806,000  of  bonds  sup- 
ported by  a  stock  issue  of  $84,000"  (then  outstanding)  "of 
which  in  our  judgment  $75,000  was  bonus  stock,  was  incon- 
sistent with  the  principles  laid  down  in  the  Rochester,  Corn- 
ing, Elmira  Case."  ^ 

The  applicant's  contention  was  that  stock  could  not  be 
sold;  and  that  if  the  bond  issue  were  not  authorized,  the  pro- 
posed extension  could  not  be  constructed.  Facing  the  alter- 
native, the  Commission  authorized  the  issue  after  inquiring  as 
to  the  applicant's  probable  ability  to  pay  the  resulting  fixed 
charges  and  reporting  that  "it  cannot  prove  by  affirmative 
evidence  that  the  returns  will  not  be  as  great  as  those  claimed 
by  the  company.  However  great  the  improbability,  it  must 
be  admitted  that  it  is  theoretically  possible  that  the  earnings 
may  take  care  of  the  interest  upon  the  bonds  as  well  as  pay 
operating  expenses  and  taxes."  The  authorization  was  ap- 
proved by  a  bare  majority,  "two  commissioners  believing  that 
the  application  should  be  granted  only  with  a  reasonable  pro- 
portion of  stock,  leaving  the  courts  to  decide  whether  such 
course  is  within  the  Commission's  power."  The  majority 
opinion  itself  pointed  out  that  "when  built  there  will  be  no 
equity  in  the  property  behind  the  bonds  to  support  and  pro- 
tect the  bondholders'  lien  except  the  $9,000  paid  in  cash  upon 
the  stock."  Throughout  the  entire  opinion  there  is  evident 
an  attempt  to  disclaim  responsibility  for  the  authorization, 
while  the  status  of  the  bonds  is  described  in  language  which, 
to  say  the  least,  would  not  be  advertised  by  brokers  attempt- 
ing to  dispose  of  the  bond  issue  authorized. 


■*  Hudson  River  and  Eastern  Traction  Company,  3  P.   S.  C.  Rep.   (and  D.,  N.  Y.) 
173,  177-iSa. 


258  FUNDED    DEBT 

"Purchasers  of  these  bonds  must  understand  clearly  that 
in  no  event  can  they  get  more  than  5  per  cent  per  annum 
upon  the  face  of  the  bonds  as  the  return,  while  if  the  earnings 
are  not  sufficient  to  meet  the  fixed  charges  there  will  neces- 
sarily be  a  default,  whereas  if  the  same  bondholders  owned 
all  the  stock  instead  of  bonds  they  would  get  as  returns  all 
that  the  road  earned  above  operating  expenses,  taxes,  and 
amortization,  and  would  run  no  more  risk  than  they  do  now 
upon  getting  their  interest  returns.  Bondholders  cannot  ex- 
pect 5  per  cent  return  unless  the  business  of  the  road  assumes 
the  magnitude  claimed  by  the  company.  Bondholders  take 
the  risk  of  smaller  earnings,  the  risk  of  the  road  not  being 
properly  kept  up  out  of  earnings,  and  in  fact  every  risk  there 
is  in  the  operation  of  the  road,  there  being  practically  no 
equity  behind  represented  by  stock  investment.  It  is  possible 
for  every  evil  which  ordinarily  follows  from  a  disproportion 
of  bonds  and  stock,  to  be  found  in  this  case.  We  are  unable 
to  understand  why  persons  with  over  $600,000  to  invest 
should  be  willing  to  do  so  for  a  5  per  cent  return  plus  a  20 
per  cent  discount  on  long-term  bonds,  knowing  they  can  get 
nothing  beyond  what  the  road  earns,  when  by  taking  stock 
they  could  get  all  it  earns  net.     But  such  seems  to  be  the  case. 

"The  company  insists  upon  building  its  road  on  bonds 
which  it  says  it  can  sell.  It  says  that  it  can  sell  no  stock  what- 
ever even  with  the  attractive  financial  conditions  above  out- 
lined      The   responsibility   of   deciding   this   question 

should  be  placed  upon  the  board  of  directors,  under  all  of  the 
circumstances  of  this  case,  and  should  not  be  assumed  by  the 
Commission.  There  is  no  positive  provision  of  law  which 
requires  the  Commission  to  assume  this  responsibility,  and 
whatever  responsibility  it  has  in  the  matter  is  not  imposed  by 
statute  but  simply  by  its  desire  to  see  methods  of  financing 
new  construction  adopted  which  will  adequately  protect  pur- 
chasers of  securities.  It  must  distinctly  disavow  in  this  case 
any  responsibility  to  the  purchasers  of  the  bonds  as  to  the 


RELATION    OF   BONDS   TO    STOCK  259 

earning  power  of  this  road,  or  as  to  the  probability  or  possi- 
bility, even,  of  the  road  paying  its  fixed  charges.  The  direc- 
tors must  assume  all  responsibility  of  putting  out  upon  the 
world  these  securities  and  of  inducing  the  people  who  have 
not  studied  this  subject  to  invest  their  money.  People  who  do 
invest  their  money  in  these  bonds  must  make  their  own  con- 
clusions as  to  their  worth  and  as  to  the  probability  of  their 
being  worth  the  sum  paid  for  them.  The  Commission  cannot 
undertake  in  this  case  to  act  as  guardian  for  them,  and  from 
the  authorization  of  these  bonds  by  the  Commission  it  must 
not  be  understood  by  any  one  that  the  Commission  considers 
them  a  safe  and  prudent  investment." 

This  opinion  has  been  quoted  at  length  not  only  because 
it  describes  dangers  resulting  from  disproportion  of  bond  to 
stock  issues,  but  also  because  it  affords  an  excellent  illustra- 
tion of  the  ambiguities  which  may  result  from  too  narrowly 
restricting  the  scope  within  which  commissions  may  exercise 
discretionary  authority.  The  applicant  had  proposed  a  pur- 
pose wholly  within  the  statute  and  was  thereby  entitled  to 
authorization  to  finance  it;  the  Commission  was  thus  called 
upon  to  authorize  an  issue  technically  within  the  statute  but 
inherently  capable  of  producing  the  very  results  which  the 
Commission  had  been  created  to  obviate.  The  Commission's 
authorization,  under  the  construction  of  the  statute  then  very 
recently  handed  down,  would  under  such  circumstances  be- 
come largely  ministerial  and  not  discretionary,  while  it  would 
be  proclaimed  far  and  wide  as  a  practical  indorsement.  Where 
it  thus  lacked  the  power  to  deal  positively  and  constructively 
with  the  application  before  it,  the  Commission  had  to  deal 
negatively,  as  it  were.  Where  it  could  not  give  practical  effect 
to  its  convictions,  it  took  advantage  of  the  opportunity  to 
register  those  convictions  so  as  to  obviate  any  misconstruction 
of  the  nature  of  its  authorization.  The  order  in  this  case  spe- 
cifically provided  that  each  certified  copy  procured  from  the 
Commission  should  have  a  copy  of  the  opinion  appended. 


26o  FUNDED    DEBT 

§  133-     Statutory   Provisions   Regulating   Proportion 

The  proper  relation  between  stock  and  bond  issues  has 
been  considered  important  enough  for  statutory  provision.  The 
Railroad  Commission  Act  of  Massachusetts  specifies  that  a 
railroad  corporation  may  issue  "its  bonds,  notes  or  other  evi- 
dences of  indebtedness  ....  to  an  amount  which  when 
added  to  the  amount  of  all  its  then  outstanding  bonds,  notes 
or  other  evidences  of  indebtedness  shall  not  cause  the  aggre- 
gate amount  of  its  bonds,  notes  and  other  evidences  of  indebt- 
edness to  exceed  twice  the  amount  of  the  capital  stock  of  the 
corporation  actually  paid  in  at  the  time  as  determined  under 
provision  of  Chapter  620  of  the  Acts  of  the  year  1906." 

A  Model  Public  Utilities  Act  drawn  up  by  the  National 
Civic  Federation  contains  a  clause  which  makes  the  determina- 
tion of  a  commission  controlling.  The  clause  follows  substan- 
tially the  Wisconsin  law  on  the  same  subject;  it  is  merely 
declaratory  of  a  principle. 

"8.  Relative  proportions  of  stocks  and  bonds.  The 
amount  of  bonds,  notes  and  other  evidences  of  indebtedness 
which  any  public  utility  may  issue  shall  bear  a  reasonable 
proportion  to  the  amount  of  stock  and  certificates  of'  stock 
issued  by  such  utility,  due  consideration  being  given  to  the 
nature  of  the  business  in  which  the  corporation  is  engaged,- 
its  credit,  future  prospects  and  earnings,  the  effect  which  such 
issue  will  have  upon  the  management  and  efficient  operation 
of  the  public  utility  by  reason  of  the  relative  amount  of  finan- 
cial interest  which  the  stockholders  will  have  in  the  corpora- 
tion and  the  circumstances  surrounding  the  operation  and 
business  of  the  corporation." 

The  Public  Utilities  Act  of  California  provides:  "The 
Commission  may  authorize  issues  of  bonds,  notes  or  other 
evidences  of  indebtedness  less  than,  equivalent  to,  or  greater 
than  the  authorized  or  subscribed  capital  stock  of  a  public 
utility  corporation  and  the  provisions  of  sections  309  and  456 
of  the  Civil  Code  of  this  State  in  so  far  as  they  contain  inhi- 


RELATION    OF    BONDS    TO    STOCK  261 

bitions  against  the  creation  by  corporations  of  indebtedness, 
evidenced  by  bonds,  notes  or  otherwise,  in  excess  of  their  total 
authorized  or  subscribed  capital  stock  shall  have  no  applica- 
tion to  public  utility  corporations." 

As  an  example  of  the  legislation  of  foreign  countries  may 
be  cited  the  provisions  of  the  Italian  law  prohibiting  the  issue 
of  bonds  for  an  amount  exceeding  the  unimpaired  paid-up 
capital  stock  of  the  corporation,  unless  the  excess  of  bond 
issue  is  guaranteed  by  a  deposit  of  national,  provincial,  or 
communal  bonds. 

§  134.     Considerations   Governing    Determination   of   Proper 
Proportion 

The  report  of  the  Committee  on  Capitalization  of  the  Na- 
tional Association  of  Railway  Commissioners,  already  re- 
ferred to,  states  generally  that  "the  ideal  relationship  between 
stocks  and  bonds  is  that  which  allows  the  corporation  to  ap- 
portion its  legitimate  earnings  upon  its  investment  so  as  to 
maintain  the  highest  degree  of  credit  and  at  the  same  time 
pay  generous  dividends  to  its  stockholders  and  retain  a  work- 
ing surplus."  ®  The  test  here  described  is  without  question  the 
measure  of  the  proportion  most  advantageous  to  all  con- 
cerned— stockholders,  bondholders,  and  patrons  of  the  utility. 
The  determination  of  the  proportion  which  will  answer  this 
test,  however,  cannot  always  be  predicated  upon  an  arithmeti- 
cal formula  which  will  first  determine  the  earnings,  and  then, 
by  assigning  so  much  for  interest  charges,  so  much  for  divi- 
dends, so  much  for  surplus,  etc.,  arrive  at  the  total  required 
amount  of  bonds  and  of  stock.  There  are  a  great  many 
other  considerations  any  one  of  which  may,  under  a  particu- 
lar set  of  circumstances,  become  controlling.  A  number  of 
factors  to  be  considered  are  specifically  referred  to  in  the 
section  above  quoted  from  the  Model  Public  Utilities  Act. 

The  considerations  which  most  often  determine  the  pro- 

•  Page  19S  of  Proceedings,  1913. 


262  FUNDED    DEBT 

portion  of  bonds  to  stock  may  be  grouped  and  discussed  from 
three  viewpoints.  The  first  is  that  of  corporate  control;  the 
second,  the  prospective  earnings  and  the  equitable  apportion- 
ment of  those  earnings  to  interest,  dividends,  etc. ;  the  third, 
relative  facilities  and  economies  in  marketing  securities  of  the 
respective  classes.  The  order  in  which  these  items  have  been 
enumerated  here  does  not  represent  an  attempt  to  indicate 
their  relative  importance.  It  is  impossible,  apart  from  a  state- 
ment of  facts,  to  assign  relative  degrees  of  importance  to  these 
matters. 

§  135.     (i)  Considerations  of  Corporate  Control 

The  importance  of  considerations  affecting  the  status  of 
corporate  control  to  be  established  or  disturbed  by  a  new  issue 
of  securities  is  noticeable  in  the  following  cases:  (a)  where 
the  capitalization  is  moderate  and  the  stock  is  to  be  held  by 
a  small  group  of  men  who  are  to  undertake  the  conduct  of 
the  enterprise;  (b)  where  the  corporation  is  organized  in  the 
interest  of  a  syndicate  or  a  holding  company  which  will  take 
and  hold  all  the  stock;  and  (c)  where  the  corporation  is  or- 
ganized as  a  feeder  to  a  railroad  or  as  an  extension  of  the 
enterprise  of  some  other  public  utility  corporation  which  will 
take  and  hold  all  or  a  majority  of  the  stock.  In  all  of  these 
cases  the  question  of  control  is  a  very  important  consideration; 
the  size  of  the  stock  issue  is  determined  by  the  amount  which 
those  who  are  to  control  the  enterprise  can  themselves  invest, 
either  through  committing  their  own  capital  or  themselves 
borrowing  from  others,  e.g.,  by  means  of  collateral  issues. 
The  problem  here  becomes,  especially  in  the  last  two  cases, 
how  to  secure  the  necessary  capital  with  a  minimum  invest- 
ment on  the  part  of  those  who  are  to  acquire  and  maintain 
control.  Choosing  one  railroad  system  almost  at  random,  for 
the  purposes  of  illustration,  it  was  Tound  that  the  total  capi- 
talization of  the  principal  company  was  divided  in  the  propor- 
tion of  43  per  cent  stock  to  57  per  cent  bonds,  while  the  com- 


RELATION    OF    BONDS    TO    STOCK  263 

bined  capitalization  of  its  subsidiary  companies  (including  all 
controlled  corporations,  whether  originally  organized  on  be- 
half of  the  principal  company  or  as  independent  projects 
which  were  later  absorbed)  was  divided  In  the  proportion  of 
29  per  cent  stock  to  71  per  cent  bonds. 

In  many  instances  where  operating  companies  attempt  to 
finance  an  extension  of  their  enterprises,  the  possibility  that 
additional  issues  of  stock  may  disturb  the  established  control 
constitutes  a  most  important  consideration.  Additional  issues 
of  stock  are  first  offered  to  the  existing  stockholders;  if  they 
cannot  absorb  the  issue,  and  if  control  of  the  company  is  a 
matter  to  be  eagerly  competed  for,  bonds  will  be  needed  to 
supply  the  greater  proportion  of  the  desired  capital. 

§  136.     (2)  Adequacy  and  Apportionment  of  Earnings 

A  bond  issue  imposes  a  burden  of  interest  charges  which 
must  be  met  currently  out  of  earnings.  It  is,  therefore,  a 
fundamental  consideration  that  the  total  debt  shall  not  be 
such  as  to  impose  a  fixed  burden  of  interest  charges  greater 
than  the  annual  earnings,  conservatively  anticipated,  will  war- 
rant, with  due  allowance  for  the  necessity  of  providing  out  of 
those  earnings  for  all  other  classes  of  fixed  charges  and  for 
dividends  on  stock,  as  well  as  appropriations  to  build  up  neces- 
sary reserves  and  surplus.  The  limitations  of  the  bond  issue 
resulting  from  this  consideration  are  inescapable.  In  the 
Rochester,  Corning,  Elmira  case  already  quoted  from,  the 
Public  Service  Commission  discusses  this  consideration  very 
fully: 

"Such  division"  (of  total  capitalization  between  stock  and 
bonds)  "should  be  made  upon  principles  easy  of  comprehen- 
sion, just  in  their  application  and  productive  of  good  results 
in  the  actual  conduct  and  operations  of  the  corporation.  It 
is  apparent  that  when  we  have  fixed  the  amount  which  should 
be  permitted  in  bonds,  we  have  necessarily  fixed  the  amount 
which  should  be  allowed  for  stock,  and  it  is  well,  therefore. 


264  FUNDED   DEBT 

to  inquire  whether  we  may  not  determine  the  division  between 
the  two  by  an  inquiry  into  the  permissible  amount  of  the  bond 
issue.  It  is  believed  that  it  would  be  of  incalculable  value  to 
the  successful  development  of  corporate  enterprises  if  there 
could  be  reasonable  certainty  that  they  would  take  care  of  the 
fixed  charges  entailed  by  bond  issues.  Certainty  of  the  pay- 
ment of  interest  with  practical  certainty  of  payment  of  prin- 
cipal cannot  be  overestimated  as  to  their  value  in  forwarding 
such  enterprises. 

"We  conceive  that  we  should  not  permit  an  issue  of  bonds 
beyond  an  amount  upon  which,  in  our  judgment,  the  enterprise 
will  be  able  to  pay  interest.  While  this  Commission  cannot  in 
any  respect  be  responsible  any  more  morally  than  it  is  legally 
for  returns  upon  bond  issues  which  it  authorizes,  it  would 
certainly  be  derelict  in  its  duty  to  the  public  if  it  permitted  a 
bond  issue  upon  which  it  was  not  fairly  reasonable  to  expect 
that  the  interest  would  be  paid  from  the  legitimate  earnings 
of  the  enterprise.  It  must  be  clearly  understood  that  in  arriv- 
ing at  conclusions  upon  so  important  and  delicate  a  point  the 
Commission  cannot  arrive  at  results  satisfactory  to  itself  and 
to  the  public  except  upon  a  conservative  basis,  and  it  would  be 
in  the  highest  degree  reprehensible  for  the  Commission  to  per- 
mit any  corporation  to  offer  bonds  upon  the  market  which  the 
Commission,  in  the  exercise  of  its  best  judgment  and  with  full 
command  of  all  the  statistical  data  regarding  the  operation  of 
roads  within  this  state,  did  not  feel  to  have  a  reasonably  satis- 
factory assurance  from  all  the  circumstances  of  the  case  that 
the  interest  would  not  be  defaulted. 

"The  amount  of  the  bond  issue  may  fairly  be  determined 
in  the  following  manner:  An  estimate  should  be  made  of  the 
probable  gross  earnings  to  accrue  from  the  operation  of  the 
road.  If  railroad  construction  and  operation  were  new  this 
would  be  a  work  of  great  difficulty.  Years  of  experience  in 
this  line  of  business  have  unquestionably  eliminated  many  of 
those  difficulties  and  should  have  established  a  sufficient  num- 


RELATION    OF    BONDS    TO    STOCK  265 

her  of  general  business  principles  to  make  the  flotation  of  such 
an  enterprise  a  subject  of  judgment  rather  than  of  speculative 
anticipation.  The  gross  earnings  being  estimated,  we  may 
next  inquire  into  the  probable  operating  expenses,  the  taxes, 
and  the  depreciation  charge,  and  after  the  respective  amounts 
of  these  are  ascertained,  any  excess  of  earnings  above  their 
aggregate  will  represent  the  sum  which  is  applicable  to  the 
payment  of  fixed  charges." 

§  137-     (3)  Relative  Ease  in  Marketing  Stocks  or  Bonds 

When  the  proportion  of  earnings  applicable  to  the  pay- 
ment of  fixed  charges  has  been  determined  as  above,  the  com- 
plete answer  will  still  be  problematical.  If  the  amount  ascer- 
tained to  be  so  applicable  is  $50,000,  a  bond  issue  of  $1,000,- 
000  would  be  warranted  at  5  per  cent  interest ;  the  question 
then  arises  whether  to  issue  bonds  at  5  per  cent  to  sell  at 
par,  or  at  4^  per  cent  to  sell  a  larger  issue  at  a  discount.  At 
this  point  the  considerations  relating  to  the  effect  of  market 
conditions  become  controlling.  The  factor  of  marketability 
is  a  complex  one  and  marks  the  point  where  the  specialized 
knowledge  of  the  banker  or  broker  must  be  brought  into  play. 
The  demand  of  investors  varies  from  time  to  time;  at  one 
period  investors  will  show  preference  for  one  class  of  securi- 
ties, and  at  another  period  will  demand  another  class.  Again, 
these  two  classes  of  securities,  stocks  and  bonds,  make  their 
appeal  to  different  groups  of  investors.  It  may  be  generally 
stated  that  stock  investments  appeal  more  to  individual  capi- 
talists, large  and  small,  because  of  the  prospect  of  profits 
greater  than  the  interest  yield  upon  bonds,  and  the  possibility 
of  speculative  profits.  On  the  other  hand,  bonds  appeal  more 
to  institutions  such  as  savings  banks,  insurance  companies, 
trust  companies,  etc.,  and  to  persons  acting  as  trustees;  they 
also  make  a  strong  appeal  to  individuals  who  have  only  sav- 
ings to  invest  and  who  will  not  commit  their  funds  to  stock 
investments  because  of  possible  uncertainty  in  payments  of 


266  FUNDED   DEBT 

dividends  or  loss  through  depreciation  of  the  value  of  the 
stock. 

The  essential  point  in  the  question  of  marketability  is  the 
determination  of  the  channels  through  which  and  the  investors 
among  which  the  securities  are  to  be  placed.  If  it  is  expected 
that  the  bonds  will  be  sold  to  ultra-conservative  investors  such 
as  insurance  and  savings  bank  companies,  trustees,  etc.,  it  is 
necessary  to  refer  to  the  laws  governing  the  investments  open 
to  such  investors.  Railroad  bonds  in  the  State  of  New  York, 
in  order  to  become  legal  investments  for  savings  banks,  must 
be  in  a  proportion  not  exceeding  three  times  the  par  value  of 
the  total  capital  stock,  while  other  than  domestic  railroad  com- 
panies must  have  earned  gross  earnings  equaling  or  exceeding 
"five  times  the  amount  necessary  to  pay  the  interest  payable 
during  that  year  upon  its  entire  outstanding  indebtedness,  and 
the  rentals  for  said  year  on  all  leased  lines." 

Stock  must  usually  be  sold  at  par;  bonds  may  be  sold  at 
a  discount  so  that  the  effective  interest  can  adjust  itself  to  the 
prevailing  interest  rates  and  market  conditions.  Bonds  may, 
therefore,  under  many  possible  conditions  be  more  readily, 
quickly,  and  economically  marketed.  It  is  the  practice  of 
state  commissions  in  authorizing  bond  issues  to  specify  the 
rate  of  discount  at  which  the  bonds  shall  be  sold,  and  in  ar- 
riving at  this  figure  they  seek  to  consider  the  effect  of  all  the 
conditions  and  circumstances  which  will  attend  the  offer  of 
the  bonds  upon  the  market. 


Part  IV  —Capitalization 


CHAPTER    XIII 

PUBLIC  REGULATION  OF  STOCK  AND  BOND 
ISSUES 

§  138.     Demand  for  Regulation 

Capitalization  and  capital  are  very  closely  related  both  in 
theory  and  in  fact,  and  what  are  commonly  spoken  of  as 
problems  of  capitalization  are  really  problems  arising  out  of 
the  acquisition  or  disposition  of  capital.  For  instance,  a  con- 
fusion between  the  nature  of  floating  capital  and  fixed  capital 
may  produce  the  situation  of  overcapitalization,  through  the 
application  of  the  proceeds  of  long-term  securities  to  floating 
capital  which  is  quickly  consumed  and  leaves  no  assets  against 
the  liability  represented  by  the  securities  outstanding.  In 
other  words,  capitalization  cannot  be  considered  as  a  thing  in 
itself.  The  purposes  of  capitalization  and  the  disposition  to 
be  made  of  the  proceeds  are  the  important  considerations. 

Although  the  general  principles  of  capitalization  obtain 
alike  for  all  corporations,  the  capitalization  of  public  service 
corporations  has  been  the  most  discussed  and  studied,  and  it 
has  been  subjected  to  a  degree  of  governmental  regulation  not 
attempted  in  the  case  of  private  corporations.  The  importance 
assigned  to  it  has  been  due  to  the  public  nature  of  the  opera- 
tions. There  has  been  a  deep-grounded  conviction  that  there 
is  a  vital  and  necessary  relationship  between  the  capitalization 
of  these  corporations  and  the  rates  and  charges  which  they 
impose.    The  public  has  therefore  demanded  full  information 

267 


268  CAPITALIZATION 

concerning  their  capitalization,  in  order  to  protect  itself  from 
supposedly  extortionate  and  unreasonable  rates.  Color  has 
been  lent  to  this  conviction  by  the  great  volume  of  judicial 
decisions  and  so-called  economic  treatises  which,  in  speaking 
of  the  return  upon  investment,  have  not  been  clear  as  to  the 
essential  difference  between  actual  investment  and  par  value 
of  stocks  and  bonds  outstanding. 

Taking  the  operations  of  any  company  as  a  whole,  there  is 
a  very  intimate  relationship  between  the  capitalization  and  the 
rates  charged,  since  the  latter  should  produce  a  total  revenue 
sufficient  to  enable  the  company  to  meet  its  interest  and  divi- 
dend obligations,  to  maintain  its  corporate  credit,  and  thus 
give  value  to  the  outstanding  stocks  and  bonds.  It  would, 
however,  be  practically  impossible  to  trace  the  relationship 
between  a  part  of  the  service  rendered  by  the  company  and  a 
parf  of  its  capitalization;  for  instance,  the  freight  rate  on  a 
bale  of  cotton  from  Dallas,  Texas,  to  New  York  is  in  no  way 
comparable  with  or  related  to  a  given  number  of  shares  of 
stock  or  so  many  bonds.  Then,  again,  in  the  case  of  large 
public  service  corporations,  railroads  for  instance,  it  never 
happens  that  all  of  the  tariff  schedules  are  brought  under  ex- 
amination in  their  entirety,  and  the  disconnected  regulation  of 
rates  to  be  charged  by  a  company  for  particular  kinds  of  ser- 
vice or  in  certain  territories  makes  the  influence  of  capitaliza-. 
tion  on  rates  very  remote  indeed,  while  in  the  original  com- 
putations of  these  rates,  considerations  of  competitive  rates 
and  of  the  amount  which  the  traffic  would  stand  were  con- 
trolling, to  the  exclusion  of  necessary  return  upon  capitaliza- 
tion. 

§  139.     Direct  and  Indirect  Regulation  of  Capitalization 

Public  regulation  of  capitalization  may  be  direct  or  indi- 
rect. It  is  direct  when  the  consent  or  determination  of  a  duly 
established  tribunal  is  necessary  to  give  validity  to  the  issu- 
ance of  securities,  and  where  that  tribunal  also  exercises  some 


REGULATION    OF    STOCK    AND    BOND    ISSUES      269 

measure  of  power  to  prescribe  the  conditions  under  which  the 
securities  shall  be  issued  and  to  direct  the  disposition  of  the 
proceeds.  It  is  indirect  when  the  regulation  does  not  extend 
to  the  issue  of  the  securities  themselves,  but  to  the  operations 
of  the  corporation,  the  establishment  of  its  rates,  regulation 
of  operating  conditions,  or  of  accounting  practice.  Indirect 
control  may  also  be  exercised  through  the  Enactment  of  stat- 
utes requiring  publicity  of  the  incidents  of  capitalization. 
While  capitalization  is  not  controlling  as  to  rates,  rates  may 
be  controlling  as  to  capitalization,  for  they  affect  earning 
power  and  thus  influence  corporate  credit.  Any  tribunal 
which  has  power  to  regulate  rates,  such  as  the  Interstate  Com- 
merce Commission,  has  an  Indirect  control  over  the  capitaliza- 
tion as  well. 

Because  of  the  close  relationship  between  capitalization 
and  capital,  the  regulation  of  accounting  must  naturally  be  a 
very  potent  factor  In  the  control  of  capitalization,  since  It  will 
largely  determine  the  disposition  of  the  proceeds  of  securities 
issued.  A  corporation  will  hesitate  to  issue  $500,000  In  securi- 
ties to  be  applied  to  purposes  for  which  it  will  be  permitted 
to  carry  only  $300,000  upon  Its  books  as  representing  perma- 
nent assets.  Control  over  the  accounts  and  requirements  as 
to  annual  and  other  reports  vests  a  great  deal  of  indirect  con- 
trol in  tribunals  having  those  powers.  The  filing  of  annual 
and  other  reports  Is  generally  comprehended  in  requirements 
for  publicity. 

§  140.     Federal  Regulation  of  Capitalization 

Direct  regulation  of  capitalization  is  vested  wholly  In  the 
several  states,  each  exercising  jurisdiction  over  the  corpora- 
tions organized  or  operating  within  Its  borders.  There  is  no 
direct  federal  regulation  of  capitalization.  The  Interstate 
Commerce  Commission,  however,  does  exercise  a  considerable 
degree  of  Indirect  control  over  corporations  doing  an  Inter- 
state business,  since  It  Is  vested  with  regulatory  authority  over 


270 


CAPITALIZATION 


the  rates,  operating  conditions,  accounts,  and  reports  of  these 
corporations.  The  Commission  has  taken  a  great  deal  of  in- 
terest in  problems  of  capitalization  and  its  decisions  contain 
many  references  to  these  problems.  It  has  consistently  main- 
tained an  agitation  for  physical  valuation  of  railroads  (now 
under  way),  claiming  it  to  be  necessary,  among  other  things, 
as  an  aid  in  the  establishment  of  rates  and  the  interpretation 
of  facts  concerning  capitalization  and  investment. 

Through  the  efforts  of  the  Interstate  Commerce  Commis- 
sion and  other  agencies  there  has  been  carried  on  for  many 
years  an  agitation  to  vest  in  the  federal  government  direct 
regulatory  power  over  the  capitalization  of  interstate  public 
utilities.  The  reason  for  the  agitation  has  been  the  inefficient 
regulation  on  the  part  of  some  states,  and  also  the  fact  that 
many  of  these  corporations  have  become  so  large  as  to  present 
problems  too  big  for  successful  disposition  by  isolated  state 
commissions.  Some  states  make  no  attempt  to  regulate  capi- 
talization, while  others  which  do  attempt  it  are  often  met  by 
very  serious  difficulties  because  of  the  interstate  character  of 
the  properties  dealt  with.  Moreover,  those  states  which  have 
attempted  to  control  capitalization  are  not  at  all  agreed  as  to 
methods  and  theories.  Interstate  carriers  passing  through 
a  number  of  states  must  seek  the  authorization  of  each  one; 
the  facts  in  the  case  and  the  merits  of  the  application  will 
necessarily  be  alike  in  all  states,  but  the  results  achieved  will 
not  be  uniform.  Some  years  ago  the  Southern  Pacific  Com- 
pany applied  to  the  Railroad  Commissions  of  California  and 
Arizona  for  approval  of  a  certain  issue  of  securities.  The 
application  was  granted  by  the  California  Commission  and 
denied  by  the  Arizona  Commission,  with  the  result  that  the 
entire  project  was  defeated.  More  recently  the  New  York, 
New  Haven  and  Hartford  Railroad  Company  had  arranged 
for  the  sale  of  $67,000,000  of  convertible  bonds,  part  of  the 
issue  to  be  used  to  refund  maturing  obligations  and  the  bal- 
ance to  provide  needed  public  facilities.    The  authorization  of 


REGULATION    OF    STOCK    AND    BOND    ISSUES      27I 

the  Rhode  Island,  Connecticut,  and  Massachusetts  Commis- 
sions was  sought.  The  first  two  authorized  the  issue  but  the 
Massachusetts  Commission  held  that  the  laws  of  that  state 
forbade  approval.  Conflicts  such  as  these,  if  attributable  to 
dififerences  in  law  or  policy  of  the  different  states,  emphasize 
the  need  for  unified  control  as  a  necessary  expedient  to  over- 
come inherent  difficulties  of  state  jurisdiction  over  interstate 
commerce  companies;  if  not  attributable  to  these  causes,  the 
conflicting  decisions  must  indicate  that  one  or  the  other  state 
is  wrong — it  erred  or  is  swayed  by  prejudice,  and  unification 
of  control  becomes  desirable  to  minimize  uncertainties  of 
regulation  which  are  due  to  peculiarities  of  temperament,  in- 
clination, or  prejudice  of  individual  comimissioners. 

The  agitation  for  federal  control  has  received  the  support 
not  only  of  many  representatives  of  the  public  but  of  many  of 
the  interstate  corporations  as  well,  the  latter  hoping  that  they 
might  thereby  be  relieved  of  some  part  of  the  ever-increasing 
burden  of  piece-meal  regulation  by  state  commissions.  State 
courts  which  have  had  to  deal  with  the  conflicting  claims  oi 
jurisdiction  set  forth  by  state  commissions  have  sometimes  ex- 
pressed a  desire  for  some  degree  of  federal  control.  The 
Maryland  Court  of  Appeals  in  deciding  against  the  Public 
Service  Commission  of  that  state  in  its  claim  of  complete 
jurisdiction  over  a  bond  issue  of  the  Baltimore  and  Ohio 
Railroad  Company  said: 

"It  may  well  be  that  the  time  will  come  when  the  jurisdic- 
tion of  the  Interstate  Commerce  Commission  will  be  so  broad- 
ened as  to  confer  upon  it  a  power  to  regulate  in  some  measure 
the  fiscal  management  of  the  great  interstate  carriers  of  this 
country,  and  enable  them  to  prevent  in  the  future  some  of  the 
ill-advised  and  unfortunate  policies  of  the  past."  ^ 

The  attitude  of  the  Interstate  Commerce  Commission  to- 
ward the  plan  of  exercising  direct  federal  control  of  capitaliza- 

'  M.  Laird  et  at..  Public  Service  Commission  v.  Baltimore  and  Ohio  R.  R.  Co.,  83 
Atl.  Rep.  348;  47  L.  R.  A.  (N.  S.)   1167  (1174)- 


272 


CAPITALIZATION 


tion  is  thus  summarized  in  its  opinion  upon  the  New  England 
investigation,  devoted  primarily  to  the  New  York,  New  Haven 
and  Hartford  Railroad: 

"In  our  opinion  the  following  propositions  lie  at  the 
foundation  of  all  adequate  regulation  of  interstate  railroads. 
....  No  stocks  or  bonds  shall  be  issued  by  an  interstate 
railroad  except  for  the  purposes  sanctioned  in  the  two  pre- 
ceding paragraphs,  and  none  should  be  issued  without  the  ap- 
proval of  the  federal  government.  .  .  .  That  such  a  measure 
of  regulation  is  necessary  and  that  it  can  only  be  administered 
through  the  national  government  is  a  necessary  conclusion 
from  the  facts  developed  in  this  proceeding." 

In  August,  19 lo,  President  Taft  appointed  a  Railroad  Se- 
curities Commission  to  inquire  into  the  feasibility  of  the 
scheme.  The  report  of  that  Commission,  rendered  in  Novem- 
ber, 191 1,  was  adverse  to  the  proposition.    It  said: 

"If  we  were  allowed  to  substitute  exclusive  federal  con- 
trol for  the  jurisdictions  of  the  several  states  over  the  railroad 
corporations,  much  could  be  said  in  behalf  of  the  establishment 
of  a  national  authority  to  supervise  both  the  issuance  of  stocks 
and  bonds  and  the  actual  expenditure  of  their  proceeds.  But 
apart  from  the  constitutional  clause  which  might  stand  in  the 
way  of  such  procedure,  the  Commission  is  of  the  opinion  that 
as  a  mere  matter  of  expediency  the  time  is  not  ripe  for  any 
such  important  or  enforcible  transfer  of  jurisdiction." 

The  proposition  for  federal  control  has  been  before  Con- 
gress continuously  for  a  number  of  years,  with  varying  meas- 
ures of  success,  but  no  bills  have  yet  been  enacted  into  law. 
Its  advocates  received  a  great  deal  of  encouragement  by  the 
hearings  before  the  Newlands  Committee  of  the  United  States 
Senate,  and  there  was  an  excellent  prospect  of  its  ueing  en- 
acted into  law  at  an  early  date,  but  this  has  been  at  least 
postponed  by  the  recent  assumption  of  operating  control  over 
railroads  by  the  federal  government.  Such  bills  as  have 
been    introduced    heretofore    have    followed   closely    similar 


REGULATION    OF    STOCK    AND    BOND    ISSUES      273 

Statutes  of  the  leading  states  and  have  not  included  any  im- 
portant feature  which  is  not  to  be  found  in  the  laws  of  some 
state.  If  federal  control  is  to  be  a  success,  however,  it  must 
be  exclusive  and  not  concurrent  with  the  several  states,  and  it 
should  not  be  necessary  for  interstate  companies  to  appeal  to 
both  the  federal  government  and  the  several  state  governments 
within  whose  jurisdiction  they  may  have  entered.  A  most 
promising  change  in  this  respect  was  the  method  of  federal 
incorporation  so  many  times  urged  by  former  President  Taft. 
This  would  have  substituted  federal  control  over  the  corpora- 
tion for  state  control  by  permitting  interstate  corporations  to 
take  out  federal  charters  and  thereafter  become  answerable  to 
the  sole  jurisdiction  of  the  federal  government,  very  much  as 
national  banks  now  are.  The  idea  was  not  favorably  received 
at  the  time,  but  now  it  is  receiving  the  active  support  of  many 
who  at  first  condemned  it.  The  tremendous  enlargement  of 
federal  powers,  caused  by  the  Great  War,  will  give  impetus 
to  the  movement  for  federal  charters. 

§  141.     State  Regulation  of  Capitalization 

It  is  only  recently  that  there  has  been  any  effective  attempt 
on  the  part  of  the  several  states  to  regulate  by  statute  the 
capitalization  of  public  service  corporations  much  beyond  the 
enactment  of  general  provisions  that  stocks  should  be  issued 
only  "for  money,  labor  done,  or  property  actually  received 
for  the  use  and  lawful  purposes  of  the  corporations."  So  far 
as  the  issue  of  bonds  was  concerned,  practically  no  restrictions 
were  imposed  beyond  those  implied  in  the  grant  of  the  power 
to  borrow  money  and  contract  debts  "when  necessary  for  the 
transaction  of  its  business,  or  the  exercise  of  its  corporate 
rights,  privileges,  or  franchises,  or  for  any  other  lawful  pur- 
poses of  its  incorporation."  There  have  been  some  other  reg- 
ulatory statutes,  enacted  in  haphazard  manner,  which  have 
contributed  but  little,  if  anything,  to  the  solution  of  general 
problems  of  capitalization. 


274 


CAPITALIZATION 


Effective  regulation  of  capitalization  came  as  an  incident 
of  the  general  state  regulation  of  public  utilities.  New  York 
in  1907  enacted  a  Public  Service  Commissions  Law  which 
represented  the  first  attempt  to  embody  in  comprehensive 
statutory  form  the  general  principles  of  regulation;  other 
states  soon  followed  the  lead  of  New  York,  many  of  them 
adopting  the  statutes  with  slight  modifications,  while  some 
others,  especially  the  leading  western  states,  have  elaborated 
considerably  thereupon. 

The  aim  and  motive  of  the  statutes  have  been  the  exam- 
ination by  an  independent  board  of  the  incidents  of  proposed 
capitalization,  and  the  assurance  of  due  publicity  of  all  the 
facts  surrounding  the  issue.  In  creating  a  body  to  exercise 
such  powers  it  was  necessary  that  the  law  should  prescribe 
the  limits  within  which,  and  the  conditions  under  which,  its 
powers  could  be  exercised.  Very  wisely  the  lawmakers,  so 
far  as  specific  provisions  concerning  capitalization  were  con- 
cerned, placed  the  emphasis  upon  the  purposes  to  which  the 
proceeds  of  the  capitalization  could  be  applied  and  left  the 
details  of  form  and  procedure  to  the  discretion  of  the  com- 
missions which  they  created.  In  this  emphasis  upon  the  pur- 
poses of  issue  lies  the  most  significant  departure  from  the 
former  attempts  to  regulate  capitalization. 

Quoting  late  Interstate  Commerce  Commissioner  Clements: 
"It  may  be  unwise  to  attempt  to  specify  the  price  and  the  man- 
ner in  which  railroad  stocks  and  securities  shall  be  disposed 
of,  but  it  is  easy  and  safe  to  define  the  purpose  for  which  they 
may  be  issued  and  to  confine  the  expenditure  of  the  money 
realized  to  that  purpose." 

In  addition  to  direct  and  immediate  control  over  capital- 
ization, state  commissions  exercise  considerable  indirect  con- 
trol over  the  capitalization  of  both  domestic  and  foreign  cor- 
porations through  the  authority  to  prescribe  operating 
rules  and  conditions,  to  pass  upon  proposed  or  existing  rates 
for  service,  to  regulate  the  extension  of  corporate  enterprises 


REGULATION    OF   STOCK   AND    BOND    ISSUES      275 

or  the  entering  of  new  corporations  into  the  field,  to  regulate 
accounting,  and  to  enforce  publicity. 

Where  the  authorization  of  a  state  commission  is  re- 
quired, securities  issued  without  the  necessary  authorization 
are  usually  declared  by  statute  to  be  void,  while  the  issuing 
corporation  is  subject  to  penalties.  Penalties  also  obtain  for 
the  diversion  of  the  proceeds  of  securities  to  purposes  other 
than  those  authorized.  Personal  penalties  attach  to  those  who 
cause  the  issue  of  unauthorized  securities  or  who  knowingly 
make  false  statements  or  representations  in  proceedings  before 
the  commissions,  or  who  file  incorrect  statements — acts  which 
some  statutes  denominate  as  misdemeanors  and  others  as 
felonies;  the  penalty  may  be  fine  or  imprisonment. 

The  efficiency  of  the  regulation  of  capitalization  by  public 
service  commissions  is  no  longer  open  to  question.  Bankers, 
investors,  and  economists  are  all  convinced  that  much  good  has 
already  been  done  within  the  few  years  that  these  laws  have 
been  in  force  and  within  a  period  which  has  of  necessity  in- 
cluded much  experimental  work. 

There  is,  however,  an  urgent  need  that  substantial  uni- 
formity be  brought  about  between  the  law  and  procedure  of 
the  several  states,  so  that  there  may  be  unanimity  of  purpose, 
agreement  as  to  principles,  and  such  a  degree  of  co-operation 
as  will  insure  due  investigation  of  every  phase  no  matter  how 
much  division  of  authority  may  be  encountered, 

§  142.     Limitations  of  State  Jurisdiction 

There  is  considerable  confusion  concerning  the  jurisdic- 
tion of  a  state  commission  over  the  stock  and  bond  issues  of 
interstate  corporations.  The  first  problem  is  that  of  jurisdic- 
tion over  the  capitalization  of  corporations  which  take  their 
corporate  powers  in  whole  or  in  part  from  that  state,  but 
where  the  proceeds  are  to  be  used  outside  the  state ;  the  second 
is  that  of  jurisdiction  over  the  capitalization  of  corporations 
doing  business  in  that  state  but  chartered  by  another  state. 


276  CAPITALIZATION 

It  is  not  proposed  at  this  point  to  enter  into  a  detailed 
analysis  of  the  statutes  and  full  discussion  of  legal  decisions; 
a  thorough  inquiry  along  those  lines  would  require  a  volume 
equal  in  size  to  this  entire  book.  It  will  be  sufficient  just 
now  merely  to  suggest  certain  general  principles  which  seem 
to  be  controlling. 

§  143.  (i)  Jurisdiction  Over  Stock  and  Bond  Issues  of  Do- 
mestic Corporations 
The  jurisdiction  of  the  New  York  Commissions  in  respect 
of  stock  and  bond  issues  extends  to  those  public  service  cor- 
porations which  are  "organized  or  existing,  or  hereafter  incor- 
porated, under  or  by  virtue  of  the  laws  of  the  State  of  New 
York."  Jurisdiction  is  thus  limited  to  domestic  corporations, 
and  concerning  these  there  are  no  restrictions  upon  the  author- 
ity of  the  commissions  by  reason  of  the  fact  that  the  proceeds 
of  capitalization  are  intended  to  be  used  outside  the  state. 
This  is  not  true,  however,  of  telephone  and  telegraph  corpora- 
tions which  are  governed  by  a  somewhat  different  statute  and 
one  that  does  not  distinguish  between  domestic  and  foreign 
corporations,  while  it  does  confine  jurisdiction  to  capitaliza- 
tion the  proceeds  of  which  are  to  be  used  within  the  state. 
The  statute  reads:  "A  telegraph  or  telephone  corporation 
may  when  authorized  by  order  of  the  commission  and  not 
otherwise,  issue  stock,  bonds,  notes  or  other  evidence  of  in- 
debtedness ....  when  necessary  for  the  acquisition  of  prop- 
erty, the  construction,  completion,  extension,  or  improvement 
of  its  facilities  or  the  improvement  or  maintenance  of  its 
service  within  the  state,  or  for  the  discharge  or  lawful  refund- 
ing of  its  obligations,  or  reimbursement  of  moneys  actually 
expended  from  the  income  from  any  source  .  .  .  ."  The 
general  policy  of  the  New  York  statute  may  be  said  to  be  that 
of  exercising  complete  jurisdiction  over  the  capitalization  of 
corporations  incorporated  pursuant  to  its  laws,  no  matter 
where  the  proceeds  of  the  capitalization  are  to  be  expended. 


REGULATION    OF   STOCK   AND    BOND    ISSUES      277 

Maryland  has  a  statute  very  similar  to  the  New  York 
statute  and  also  empowering  the  Commission  of  that  state  to 
authorize  the  issue  of  stocks  and  bonds  by  corporations 
"organized  or  existing,  or  hereafter  incorporated,  under  or  by 
virtue  of  the  laws  of  the  State  of  Maryland."  This  clause 
came  before  the  Court  of  Appeals  of  that  state  for  construc- 
tion upon  the  action  of  the  Commission  seeking  to  enjoin  the 
Baltimore  and  Ohio  Railroad  from  issuing  $63,250,000  of 
bonds,  convertible  into  common  stock,  the  proposed  issue  of 
which  had  been  theretofore  announced  by  that  company  but 
without  the  authorization  of  the  Commission  having  been 
sought.^  The  position  of  the  Commission  was  described  by 
the  court  as  follows: 

"By  reason  of  the  location  of  the  home  office  of  the  com- 
pany in  Maryland,  it  claims  to  possess  a  right  to  control  the 
expenditure  of  moneys,  the  creating  and  issue  of  evidences  of 
indebtedness,  the  prices  at  which  such  bonds  or  debentures 
shall  be  marketed,  the  necessity  and  expediency  of  the  creation 
of  this  indebtedness;  in  general,  to  direct  the  entire  physical 
and  fiscal  policy  of  one  of  the  great  common  carriers  of  this 
country  over  its  entire  system  of  4,450  miles  of  railroad,  of 
which  but  281  are  within  the  state  and  4,169  located  without 
the  state,  and  one  of  which  other  states  (West  Virginia) 
might  with  equal  propriety,  by  reason  of  the  confirmatory  act 
of  Virginia  of  1827  and  the  far  greater  amount  of  mileage 
in  that  state,  make  a  similar  claim.  The  statement  of  the 
claim,  taken  with  the  terms  of  the  act  of  1910,  would  seem 
to  afford  a  conclusive  answer  to  the  proposition.  When  the 
act  is  carefully  limited  by  its  very  terms  to  operations  within 
this  state,  any  line  of  reasoning  which  aims  to  extend  it  be- 
yond is  alike  in  flat  contradiction  of  the  act  and  entirely  beyond 
the  power  of  the  state  to  adopt." 

In  saying  that  the  Act  was  limited  "by  its  very  terms  to 


'  Laird  et  al.  Public  Service  Commission  v.  Baltimore  &  Ohio  R.  R.  Co.,  47  L.  R.  A. 
(N.  S.)   1167  (1171)- 


278  CAPITALIZATION 

operations  within  this  state,"  the  court  had  in  mind  the  other 
sections  of  the  statute  which  prescribed  the  general  jurisdic- 
tion of  the  Commission  as  extending  to  railroads  "lying  within 
this  state,  and  to  the  person  or  corporation,  owning,  leasing, 
operating  or  controlling  the  same,"  etc.,  and  "to  any  common 
carrier  operating  or  doing  business  within  the  state."  These 
sections  also  are  similar  to  the  New  York  statute. 

The  court  held  that  an  interstate  carrier  may  be  made 
"subject  to  the  control  of  each  state  as  to  matters  affecting 
the  operations  of  the  company  in  such  state,  but,  beyond  that, 
state  legislation  is  powerless  without  striking  at  the  very 
fundamentals  of  rights  as  recognized  in  our  government.  So 
far  as  the  issue  of  securities  is  concerned,  the  state  may,  by 
virtue  of  its  police  power,  require  such  applications,  reports, 
and  statements  to  be  filed  as  have  a  tendency  to  show  whether 
the  proposed  issues  are  bona-fide  and  for  value ;  ^  but  the 
determination  of  the  correct  capitalization  or  bonded  indebt- 
edness is  a  power  which  was  in  terms  conferred  on  the  Balti- 
more and  Ohio  Railroad  by  its  charter  ....  and  which  the 
state  has  not  the  power  to  detract  from  or  annul." 

The  last  sentence  of  the  above  quotation  (here  italicized 
for  emphasis)  suggests  a  limitation  in  the  specific  case  then 
before  the  court  and  which  was  then  controlling,  thus  restrict- 
ing the  usefulness  of  the  decision  as  a  precedent.  There  are 
not  many  public  service  corporations  (except  a  few  of  the 
oldest  railroad,  bridge,  or  water  corporations)  whose  charters 
may  not  be  amended  or  modified  by  the  incorporating  state. 
When  the  decision  in  the  Dartmouth  College  Case  (1819) 
first  held  that  a  state  could  not  alter  or  amend  a  charter 

•The  court  apparently  upheld  the  determination  of  the  Circuit  Court  from  which 
the  appeal  had  been  taken  and  which  had  held:  "It  is  proper  to  require  the  Baltimore 
and  Ohio  Railroad  Company  to  file  an  application  or  report  with  the  Public  Service 
Commission,  stating  with  reasonable  fullness  such  facts  as  may  be  requisite  to  enable  the 
commission  and  those  legitimately  interested  therein  to  ascertain  whether  any  proposed 
issue  or  issues  of  bonds  or  certificates  of  indebtedness  is  -or  are  in  fact  bona-fide  and  for 
value;  but  beyond  that  it  is  not  subject  to  the  jurisdiction  of  said  commission  as  to 
the  financing  of  the  system  known  as  the  Baltimore  and  Ohio  Railroad  Company,  ex- 
tending through  a  number  of  states,  either  in  respect  to  determining  the  aggregate 
amount  of  capital  stock,  bonded  indebtedness,  the  prices  at  which  its  bonds  or  certifi- 
cates of  indebtedness  shall  be  sold,  or  where  or  how  the  moneys  realized  from  the 
sale  thereof  shall  be  expended." 


REGULATION    OF   STOCK   AND    BOND    ISSUES      279 

already  granted  by  it  unless  that  state  had  specifically  reserved 
the  right  so  to  do,  most  states  promptly  enacted  statutes  or 
amended  their  constitutions  so  as  clearly  to  reserve  the  right 
ever  after.  In  1827  the  New  York  Revised  Statutes  provided 
that:  "The  charter  of  every  corporation,  that  shall  hereafter 
be  granted  by  the  legislature,  shall  be  subject  to  alteration, 
suspension  and  repeal,  in  the  discretion  of  the  legislature." 
In  1846  a  provision  of  like  effect  was  carried  into  the  Consti- 
tution. 

Statutes  conferring  jurisdiction  upon  commissions  group 
together  stocks,  bonds,  and  other  evidences  of  indebtedness  as 
though  all  of  these  were  subject  to  identically  the  same  con- 
sideration in  all  cases.  The  decision  of  the  Maryland  court 
also  said:  "What  has  been  said  already  applies  equally  well 
to  the  increase  of  capital  stock  or  the  convertibility  of  bonds 
into  stock  upon  stipulated  terms  and  conditions."  Stocks, 
however,  are  essentially  different  in  nature  from  bonds  and 
other  forms  of  corporate  indebtedness,  so  that  there  may, 
properly  enough,  be  circumstances  in  which  the  jurisdiction 
of  a  commission  will  depend  upon  whether  stock  or  bonds  are 
to  be  issued. 

The  authority  to  issue  stock  is  of  the  essence  of  incorpora- 
tion and  it  must  of  necessity  come  in  the  first  instance  from 
the  state  which  gave  incorporation.  Stock  issued  beyond  the 
amount  authorized  in  the  charter  is  void  and  cannot  be  legal- 
ized by  the  act  of  any  other  state;  on  the  other  hand,  the 
issue  of  stock  authorized  in  the  charter  will  be  valid  unless 
the  state  granting  the  charter  makes  some  other  requirement. 
If  that  further  requirement  is  complied  with,  no  other  state 
can  render  the  issue  invalid.  It  would  therefore  appear,  as  a 
general  rule,  that  the  state  creating  the  corporation  has  abso- 
lute and  exclusive  inherent  jurisdiction  over  the  issue  of  stock 
no  matter  where  or  how  the  proceeds  are  to  be  spent.  It  is, 
of  course,  a  matter  of  legislative  discretion  how  much  of  that 
inherent  jurisdiction  shall  be  actively  exercised. 


28o  CAPITALIZATION 

The  execution  of  a  bond,  whether  it  be  secured  by  a 
mortgage  or  not,  and  the  creation  by  the  corporation  of  any 
other  claim  against  itself,  must  be  predicated  in  the  first  in- 
stance upon  the  general  authority  of  the  corporation  to  borrow 
money.  Even  though  the  authority  to  borrow  money  and  in- 
cur indebtedness  is  uniformly  regarded  as  one  of  the  incidental 
powers  of  every  corporation,  the  existence  of  the  authority 
must  be  ascribed  to  the  grant  of  charter  rights.  If  that  char- 
ter, then,  is  subject  to  the  control  of  the  grantor,  the  latter 
may  prescribe  any  reasonable  condition  for  the  exercise  of  any 
right  granted  thereby.  Hence,  it  seems  correct  to  hold  that 
jurisdiction  over  the  issue  of  bonds  by  any  corporation  is 
vested  primarily  in  the  state  under  whose  laws  it  has  been 
incorporated. 

The  execution  of  a  mortgage  to  secure  bonds  is  an  entirely 
different  proposition.  The  power  to  mortgage  is  closely  re- 
lated to  the  power  to  sell,  since  a  mortgage  is  ineffective  un- 
less it  carries  with  it  the  authority  to  sell  the  property  to  satisfy 
the  demands  of  mortgagees.  Each  state  has  absolute  and  com- 
plete jurisdiction  over  the  ownership  and  use  of  property 
within  its  borders,  and  it  may  regulate  or  legislate  in  relation 
to  its  acquisition  or  sale  by  all  classes  of  corporations.  So  far 
as  the  power  to  create  a  lien  on  property  is  concerned,  each 
state  may  grant  and  control  the  power  to  the  extent  that  it 
affects  property  within  its  borders,  and  while  the  state  creating 
a  corporation  may  grant  authority  for  the  latter  to  mortgage 
its  properties,  that  authority  can  have  no  extra-territorial 
force  and  effect,  and  the  corporation  may  not  plead  it  as  war- 
rant for  encumbering  its  property  in  another  state  if  that  other 
state  chooses  to  lay  down  different  regulations.  The  author- 
ity to  borrow  money  must  come  from  the  state  conferring  in- 
corporation, in  the  first  instance,  but  the  authority  to  give 
security  for  the  loan  by  way  of  lien  upon  realty  must  come 
from  the  state  in  whose  jurisdiction  the  property  is  located. 

It  will  be  urged  that  if  the  state  conferring  incorporation 


REGULATION    OF    STOCK   AND    BOND    ISSUES      281 

can  exercise  complete  jurisdiction  over  the  issue  of  stock  or 
the  borrowing  of  moneys  no  matter  where  the  proceeds  there- 
of are  to  be  spent,  it  will  be  required  to  authorize  issues  for 
purposes  concerning  the  necessity  or  cost  or  other  details  of 
which  it  can  have  but  meager  and  incomplete  information. 
The  final  effect  of  such  a  situation  is  bound  to  be  that  the  law 
which  created  and  defined  the  powers  of  the  commission  in 
respect  to  regulation  of  capitalization  will  operate  to  defeat 
its  own  ends.  In  the  mind  of  the  Maryland  Court  of  Appeals 
whose  decision  in  Laird  v.  Baltimore  and  Ohio  Railroad  Co. 
has  been  already  cited,  this  difficulty  appeared  to  be  a  very 
serious  one,  "It  appears  that  some  or  a  considerable  portion 
of  the  moneys  to  be  raised  are  to  be  expended  beyond  the 
limits  of  the  State  of  Maryland  in  the  acquisition,  extension, 
improvement  or  maintenance  of  the  facilities  or  terminals  of 
the  railroad.  Manifestly  the  Public  Service  Commission  of 
this  state  is  not  and  could  not  be  invested  by  the  legislature  of 
this  state  with  any  supervisory  powers  over  the  expenditures 
of  moneys  in  other  states,  nor  the  apportionment  of  the  ex- 
penditures of  its  moneys  as  between  different  states,  nor 
could  it  pass  upon,  approve,  or  condemn  the  wisdom  or  un- 
wisdom of  construction  work  to  be  performed  in  Virginia, 
West  Virginia,  Ohio,  Indiana,  Illinois,  Missouri,  Delaware, 
and  other  states." 

The  contention  is  well  taken,  but  it  does  not  affect  the 
question  of  inherent  jurisdiction;  rather  it  exemplifies  the  de- 
fects in  the  existing  systems  of  divided  authority.  The  solu- 
tion of  the  difficulty  lies  not  so  much  in  the  limitation  of 
state  jurisdiction  as  it  does  in  the  creation  of  a  more  compre- 
hensive one,  to  wit,  a  federal  jurisdiction. 

§  144.     (2)  Jurisdiction  Over  Stock  and  Bond  Issues  of  For- 
eign Corporations 

The  whole  problem  of  the  constitutional  right  of  a  state 
to  control  the  capitalization  of  foreign  corporations  is  as  fine 


282  CAPITALIZATION 

a  question  of  law  as  can  be  presented;  unanimity  as  to  the 
answer  can  hardly  be  hoped  for. 

A  state  which  seeks  to  exercise  jurisdiction  over  the  capi- 
talization of  a  foreign  corporation  must  manifestly  base  its 
claim  upon  some  ground  other  than  the  inherent  right  to  con- 
trol a  creature  of  its  own  statutes.  Hence  that  basis  must  be 
found  in  the  police  power  of  the  state,  and  the  right  to  control 
the  corporate  property  or  activities  in  that  state.  Each  state 
has  absolute  jurisdiction  over  the  ownership  and  use  of  prop- 
erty within  its  borders,  and  it  also  can  exercise  a  considerable 
degree  of  regulation  over  corporations  which  will  submit  to 
its  laws  for  the  purpose  of  doing  business  within  its  borders. 
In  a  leading  case  the  Supreme  Court  of  the  United  States 
described  the  relation  of  a  state  to  foreign  corporations  as 
follows: 

"The  corporation  being  the  mere  creation  of  local  law, 
can  have  no  legal  existence  beyond  the  limits  of  the  sovereignty 

where  created The  recognition  of  its  existence  even  by 

other  states,  and  the  enforcement  of  its  contracts  made  therein, 
depend  purely  upon  the  comity  of  those  states — a  comity 
which  is  never  extended  where  the  existence  of  the  corpora- 
tion or  the  exercise  of  its  powers  are  prejudicial  to  their  inter- 
ests or  repugnant  to  their  policy.  Having  no  absolute  right 
of  recognition  in  other  states,  but  depending  for  such  recogni- 
tion and  the  enforcement  of  its  contracts  upon  their  assent, 
it  follows,  as  a  matter  of  course,  that  such  assent  may  be 
granted  upon  such  terms  and  conditions  as  those  states  may 
think  proper  to  impose.  They  may  exclude  the  foreign  cor- 
poration entirely;  they  may  restrict  its  business  to  particular 
localities,  or  they  may  exact  such  security  for  the  perform- 
ance of  its  contracts  with  their  citizens  as  in  their  judgment 
will  best  promote  the  public  interest.  The  whole  matter  rests 
in  their  discretion."  * 

In  its  dealings  with  foreign  corporations  engaged  in  inter- 

*Paul  V.  Virginia,  8  Wall.  168  (17.1). 


REGULATION    OF    STOCK    AND    BOND    ISSUES      283 

State  commerce,  however,  the  state  must  observe  definite  limi- 
tations upon  its  general  authority,  for  "to  carry  on  interstate 
commerce  is  not  a  franchise  or  a  privilege  granted  by  the 
state;  it  is  a  right  vi^hich  every  citizen  of  the  United  States  is 
entitled  to  exercise  under  the  Constitution  and  laws  of  the 
United  States;  and  the  accession  of  mere  corporate  facilities, 
as  a  matter  of  convenience  in  carrying  on  their  business,  can- 
not have  the  effect  of  depriving  them  of  such  right,  unless 
Congress  should  see  fit  to  interpose  some  contrary  regulations 
on  the  subject."  ^ 

A  number  of  states  declare  their  jurisdiction  over  the  capi- 
talization of  public  service  corporations  in  the  following  terms: 
"The  power  of  public  utilities  to  issue  stocks,  stock  certifi- 
cates, bonds,  notes  and  other  evidences  of  indebtedness,  and 
to  create  liens  on  their  property,  is  a  special  privilege,  the  right 
of  supervision,  the  regulation,  restriction,  and  control  of  which 
is  and  shall  continue  to  be  vested  in  the  state.  Such  power 
shall  be  exercised  by  the  commission  hereby  created  accord- 
ing to  the  provisions  of  this  act  and  under  such  rules  and. 
regulations  as  the  commission  may  prescribe." 

It  will  be  noted  that  this  declaration  does  not  distinguish 
between  the  status  of  domestic  or  foreign  corporations,  while 
it  is  quite  apparent  that  there  must  be  some  difference  in  the 
nature,  quality,  or  extent  of  regulation  to  which  they  may  be 
subjected.  It  then  proceeds  to  include  in  one  general  classi- 
fication stock,  bonds,  and  the  power  to  create  liens. 

A  declaration  by  the  legislature  cannot,  obviously,  operate 
to  confer  constitutional  authority  where  that  authority  has 
not  heretofore  existed.  This  inclusion  of  provisions  such  as 
the  above,  therefore,  does  not  help  to  throw  any  light  on  the 
situation,  and  the  states  which  have  enacted  these  declarations 
are  in  no  respect  placed  in  a  stronger  situation  than  those  who, 
without  specific  declaration,  have  proceeded  to  enact  regu- 
lating statutes  applicable  to  all  classes  of  corporations  without 

*  Crutcher  v.  Kentucky,  141  U.  S.  47  (57)- 


284  CAPITALIZATION 

distinction  between  domestic  and  foreign  corporations.  To 
declare  certain  acts  to  be  subject  to  regulation  is,  of  course, 
eminently  proper,  provided,  however,  they  are  acts  over  which 
the  state  may  exercise  jurisdiction  by  inherent  right. 

There  should  first  be  considered  the  inclusion  of  the 
"power  to  issue  stock  and  stock  certificates"  among  the  "special 
privileges"  subjected  to  state  supervision  and  regulation. 
While  the  state  may  be  permitted  to  exercise  a  great  degree  of 
regulation  over  the  activities  of  a  foreign  corporation  operat- 
ing within  its  borders,  its  authority  is  limited  to  the  acts  of  the 
corporation  in  relation  to  the  corporate  operations,  and  cannot 
be  extended  to  the  organization  of  the  corporation  or  to  those 
acts  which  the  corporation  becomes  entitled  to  perform  by 
virtue  of  the  power  which  gave  it  existence.  As  already 
pointed  out,  the  issue  of  stock  is  of  the  essence  of  the  corpora- 
tion and  must  come  from  the  authorization  of  the  incorporat- 
ing state;  if  the  latter  has  not  authorized  the  issue  of  stock,  no 
other  state  can  grant  the  required  authority;  the  authority  of 
the  incorporating  state  is  inherent  and  therefore  primary,  and 
no  other  state  can  exercise  a  power  which  will  tend  to  impeach 
or  question  the  authority  of  that  state. 

"A  special  privilege"  is  the  same  thing  as  a  "special  fran- 
chise." The  right  to  issue  stock  is  a  right  conferred  upon  the 
incorporators  who  organize  and  who  later  compose  the  cor- 
poration ;  it  cannot,  therefore,  be  a  "special  franchise"  of  the 
corporation  itself,  to  wit,  a  right  which  may  be  wholly  taken 
away  from  the  corporation  and  still  leave  the  corporation  it- 
self intact.  This  being  true,  it  must  follow  that  the  authoriza- 
tion to  issue  stock  must  come  not  only  primarily  but  exclusively 
from  the  state  conferring  jurisdiction,  and  no  other  state  may 
acquire  supplemental  jurisdiction. 

The  power  to  borrow  money  and  incur  indebtedness  pre- 
sents a  different  problem  and  one  which  rests  on  very  debat- 
able ground.  The  primary  authority  must  come  from  the 
incorporating  state,  but  since  the  power  is  an  essential  and 


REGULATION    OF    STOCK    AND    BOND    ISSUES      285 

necessary  accompaniment  of  the  very  authority  to  engage  in 
business,  and  a  natural  incident  of  the  corporation's  deahngs 
with  others  in  the  regular  course  of  business,  it  may  be  argued 
that  it  becomes  so  intimately  connected  with  the  general  cor- 
porate activities  as  to  be  within  like  control  as  that  affecting 
the  operations  of  the  corporation  within  each  state.  It  would 
be  rash  to  venture  an  opinion  upon  the  general  proposition, 
for  specific  instances  may  present  special  considerations  which 
will  become  controlling.  A  decision  in  favor  of  the  authority 
of  each  state  (other  than  the  one  conferring  incorporation) 
to  regulate  the  borrowing  of  money  and  the  incurring  of  in- 
debtedness for  purposes  forming  part  of  the  corporate  opera- 
tions in  that  state  will  undoubtedly  best  serve  the  ends  of 
public  policy. 

The  power  to  create  liens  on  property  is  clearly  subject  to 
the  regulation  of  the  state  within  whose  jurisdiction  the  prop- 
erty is  located.  The  assumption  of  authority  in  this  case  has 
nothing  whatever  to  do  with  the  question  of  jurisdiction  over 
the  power  to  borrow  money;  it  springs  out  of  the  unquestioned 
right  to  control  property  located  within  the  state,  and  the  state 
once  acquiring  jurisdiction  on  that  basis  may  proceed  to  exer- 
cise it  over  every  phase  of  the  proposed  capitalization.  So 
far  as  the  perfecting  of  this  jurisdiction  is  concerned,  the  place 
where  the  proceeds  are  to  be  spent  would  appear  to  be  im- 
material; even  if  the  proceeds  were  to  be  spent  wholly  out- 
side the  state,  the  authority  of  the  state  wherein  the  property 
to  be  encumbered  is  located  would  nevertheless  continue  to  be 
essential.  In  this  respect  statutes  similar  to  those  of  New 
York  relating  to  telegraph  and  telephone  corporations,  and 
which  take  expenditures  within  or  without  the  state  as  the 
test  of  jurisdiction,  are  perhaps  defective. 


CHAPTER   XIV 

THE  TASK  OF   PUBLIC   SERVICE   COMMISSIONS 
IN  REGULATING  CAPITALIZATION 

§  145.     Statutory  Purposes  for  Which  Capitalization  May  Be 
Authorized 

The  Public  Service  Commissions  Law  of  New  York  pro- 
vides that  a  corporation  subject  thereto  may,  under  the  au- 
thority of  the  Commission,  "issue  stocks,  bonds,  notes  or  other 
evidences  of  indebtedness  payable  at  periods  of  more  than 
twelve  months  after  the  date  thereof,  when  necessary  for  the — 

1.  Acquisition  of  property, 

2.  Construction,   completion,   extension  or  improvement 

of  its  faciHties  (railroad,  telephone,  and  telegraph), 
and  of  its  plant  or  distributing  system  (gas  or 
electric), 

3.  Improvement  or  maintenance  of  its  service, 

4.  Discharge  or  lawful  refunding  of  its  obligations, 

5.  Reimbursement  of  moneys  actually  expended  fromin- 


The  order  of  the  Commission  must  state  "the  purposes  to 
which  the  issue  or  proceeds  thereof  are  to  be  applied,  and  that, 
in  the  opinion  of  the  Commission,  the  money,  property  or 
labor  to  be  procured  or  paid  for  by  the  issue  of  such  stock, 
bonds,  notes  or  other  evidence  of  indebtedness  is  or  has  been 
reasonably  required  for  the  purposes  specified  in  the  order." 

The  statutes  of  many  other  states  are  very  similar  to  that 
of  New  York  in  the  enumeration  of  purposes  to  which  the 

*  Words  in  parentheses  not  found  in  the  law. 

286 


TASK    OF   PUBLIC   SERVICE    COMMISSIONS         28/ 

proceeds  of  capitalization  may  be  applied;  some  states  have 
substituted  or  added  more  general  purposes,  while  a  few  have 
attempted  greater  detail.  A  comprehensive  analysis  of  all  the 
statutes  on  the  subject  is  impracticable,  hence  the  discussion 
here  is  confined  largely  to  the  New  York  statute  which  is 
fairly  typical.  In  the  following  chapters  are  discussed  the 
general  principles  governing  capitalization  for  each  of  the 
purposes  above  described. 

In  its  first  annual  report  the  Second  District  Commission 
described  the  enumeration  of  purposes  in  the  statute  as  being 
"exclusive  and  not  inclusive;  that  stocks  and  bonds  may  not 
be  issued  for  purposes  not  enumerated  in  the  statute,  either 
with  or  without  the  authority  of  the  Commission."  The  early 
decisions  of  that  Commission  indicated  some  doubts  as  to  the 
sufficiency  of  the  enumerated  purposes;  the  Commission  once 
expressed  the  opinion,  reached  "after  full  discussion,"  that 
"power  should  be  given  to  it  to  authorize  the  issue  of  stock, 
bonds  and  other  evidence  of  indebtedness  for  some  corporate 
purposes  not  now  enumerated.  .  .  .  We  are  constrained  to 
believe  that  the  section  could  be  made  more  comprehensive 
without  danger  to  the  spirit  of  the  law  and  with  benefit  to 
proper  corporate  operations."  ^  There  was  no  intimation  of 
what  other  purposes  the  Commission  would  have  included, 
while  in  a  case  decided  later  it  apparently  went  on  record  as 
approving  of  the  sufficiency  of  the  corporate  purposes  enumer- 
ated in  the  statute,  saying: 

"If  the  company,  upon  its  application  for  the  consent  of 
the  Commission,  can  point  out  that  it  desires  to  use  the  money 
for  one  of  the  purposes  specified  in  the  statute,  that  consent 
will,  of  course,  be  given  in  a  proper  case.  If  it  has  expended, 
previously,  money  from  its  treasury  which  would  entitle  the 
bonds  from  the  trustee,  of  course  it  can  obtain  them  by  reason 
of  that  fact.  The  statute  simply  limits  to  some  extent  the 
purposes  for  which  the  money  derived  from  the  sale  of  such 

»  Matter  of  Erie  R.  R.  Co.,  i  P.  S.  C.  Rep.   (ind  D.,  N.  Y.)   115   (126). 


288  CAPITALIZATION 

bonds  can  be  applied.  If  it  desires  to  use  the  money  for  the 
acquisition  of  property;  for  the  discharge  or  lawful  refund- 
ing of  its  obligations,  or  for  the  extending  or  improving  of 
its  facilities,  or  improving  or  maintaining  its  service,  it  can  do 
so,  and  practically  the  only  other  purpose  for  which  it  could 
wish  to  use  the  money  would  be  to  declare  dividends.  Cor- 
porations can  easily  adjust  themselves  to  this  statute,  and  it  is 
apprehended  no  embarrassment  need  be  expected  in  its  opera- 
tion." ' 

That  the  purposes  enumerated  have  been  sufficient  for  all 
proper  purposes  of  corporate  financing  has  since  been  demon- 
strated by  the  fact  that  during  more  than  ten  years  of  its 
operation  there  has  been  no  serious  attempt  to  amend  the  law 
in  this  respect,  while  the  absence  of  complaints  has  indicated 
that  corporations  have  not  suffered  material  hardship  in  adapt- 
ing their  practices  to  the  statute. 

§  146.     Scope  of  Commission's  Authority 

Financing,  whether  public  or  private,  is  a  thing  which  de- 
mands considerable  elasticity ;  it  may  be  regulated,  but  it  must 
not  be  fettered.  Corporate  financing  in  order  to  be  successful 
must  take  advantage  of  opportunities,  be  free  to  bargain, 
ready  to  respond  to  favorable  influences  and  to  adopt  expedi- 
ents if  unfavorable  circumstances  prevail. 

Hence,  if  the  state  is  to  regulate  financing,  it  must  also 
co-operate.  The  commission  charged  with  authority  may  at 
times  be  required  to  use  that  authority  as  veto  power,  to  pre- 
vent or  prohibit;  but  most  often  it  must  exercise  it  in  open  co- 
operation. The  function  of  regulating  laws,  therefore,  can 
best  be  that  of  declaring  the  policy  and  purpose  of  the  state, 
and  of  prescribing  the  limits,  made  sufficiently  wide,  within 
which  those  charged  with  the  administration  of  the  laws  may 
work  with  those  engaged  in  financing,  sharing  in  common  the 
purpose  of  maintaining  the  integrity  of  invested  capital,  in- 

3  Lehigh  &  Hudson  River  R.  R.  Co.,  i  P.  S.  C.  Rep.   (2nd  D.,  N.  Y.)  224  (231). 


TASK    OF    PUBLIC    SERVICE    COMMISSIONS         289 

viting  new  capital  on  reasonable  terms,  and  in  general  to 
assure  the  continuance  and  adequate  expansion  of  the  facili- 
ties for  public  service. 

§  147,     (i)  Application  of  the  Statute 

The  New  York  Public  Service  Commission  for  the  Second 
District  thus  describes  the  intent,  in  retrospect  as  well  as  in 
prospect,  of  the  statute  under  which  it  works: 

"Money  to  be  acquired  from  the  sale  of  stocks,  bonds,  or 
other  evidence  of  indebtedness,  payable  at  a  period  of  more 
than  twelve  months  after  the  date  thereof,  is  money  secured 
by  capitalization,  and  the  spirit  of  the  act  is  to  control  capitali- 
zation; to  see  that  it  is  made  only  for  certain  legitimate  pur- 
poses, and  then  only  to  an  amount  that  is  necessary  for  the 
reasonable  accomplishment  of  such  purposes;  ....  to  re- 
strain and  limit  the  hitherto  irresponsible  elasticity  of  corpor- 
ate capitalization  to  the  matters  which  may  properly  be  capi- 
talized." * 

The  Court  of  Appeals  of  New  York  in  the  first  important 
case  brought  before  it  in  respect  of  the  regulation  of  capitali- 
zation, described  the  same  statute  as  follows: 

"The  paramount  purpose  of  the  enactment  of  the  Public 
Service  Commissions  Law  was  the  protection  and  enforcement 

of  the  rights  of  the  public For  a  generation  or  more 

the  public  has  been  frequently  imposed  upon  by  the  issues  of 
stocks  and  bonds  of  public  service  corporations  for  improper 
purposes,  without  actual  consideration  therefor,  by  company 
officers  seeking  to  enrich  themselves  at  the  expense  of  inno- 
cent and  confiding  investors.  One  of  the  legislative  purposes 
in  the  enactment  of  this  statute  was  to  correct  this  evil  by 
enabling  the  commission  to  prevent  the  issue  of  such  stock  and 
bonds,  if  upon  an  investigation  of  the  facts  it  is  found  that 
they  were  not  for  the  purposes  of  the  corporation  enumerated 
by  the  statute  and  reasonably  required  therefor It  was 

*  Lehigh  &  Hudson  River  R.  R.  Co.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  224  (229,  232). 


290 


CAPITALIZATION 


designed  to  make  the  commissioners  the  guardians  of  the 
public  by  enabling  them  to  prevent  the  issue  of  stock  and 
bonds  for  other  than  the  statutory  purposes."  ' 

The  statute  quoted  is  very  general  in  its  terms;  there  is 
no  attempt  to  describe  in  detail  the  class  or  kind  of  property 
which  may  be  acquired,  to  prescribe  a  rule  for  the  determina- 
tion of  value  for  capitalization  purposes,  or  to  enumerate  and 
define  the  costs  properly  includible  in  "construction,  com- 
pletion, extension  or  improvement  of  its  facilities,"  and  in 
"improvement  or  maintenance  of  its  service."  What  the 
statute  prescribes  is,  "first,  that  capital  shall  be  secured  by  the 
issue;  second,  that  the  issue  of  such  stock,  bonds,  or  other  evi- 
dence of  indebtedness  is  necessary  to  obtain  such  capital  for 
one  or  more  of  the  four  purposes  ®  enumerated  in  this  section ; 
third,  that  the  amount  authorized  is  reasonably  required  for 
one  or  more  of  such  purposes.  When  any  one  of  these  ele- 
ments is  lacking  in  an  important  case  the  Commission  has  no 
right  to  issue  an  order  authorizing  the  desired  issue,"  ^ 

§  148.     (2)  Incidents  of  Capitalization  to  Be  Considered  by 
Commission 

The  statute  suggests  the  principle,  and  requires  the  Com- 
mission to  work  out  the  details.  Because  of  the  great  latitude 
allowed  these  commissioners  for  the  exercise  of  sound  discre- 
tion and  judgment,  the  careful  study  of  the  record  which  they 
have  made  becomes  very  important  for  those  who  desire  to 
know  just  what  limitations  are  to  be  imposed. 

"The  provisions  of  the  law  regulating  capitalization  of 
public  service  corporations  are  general  in  terms  and  are  de- 
signed to  embrace  cases  of  all  classes,  those  presenting  difficult 
conditions  and  pressing  necessity  as  well  as  those  relating 
simply  to  the  refunding  of  prior  liens  or  the  raising  of  capital 


'  People  ex  ret.   Delaware  &  Hudson  Co.  v.   Stevens,  19"  N.  Y.   1. 
'  The  fifth  purpose,  i.e.,  reimbursement  of  income,  is  disregarded  because  it  relates 
to  expenditures  which  have  alreadv  been  made. 

•  Matter  of  Erie  R.  K.  Co.,   1   1>.  S.  C.  Rep.   {2nd.  D.,  N.  Y.)   115  d^o). 


TASK    OF   PUBLIC    SERVICE    COMMISSIONS         291 

for  the  acquisition  of  property  or  for  improvements  by  the 
sale  of  bonds  which  are  marketable  at  or  near  par  value.  Upon 
all  cases  of  capitalization  the  law  intends  that  the  Commis- 
sion shall  act  with  comprehensive  knowledge  of  the  financial, 
physical,  operating  and  traffic  conditions  pertaining  to  the 
property  sought  to  be  charged  with  new  capital,  and  that  per- 
mission to  raise  new  capital  shall  be  granted  in  those  cases 
where  the  kind  of  bonds,  the  security  upon  which  they  are 
based,  the  terms  of  proposed  sale  or  exchange,  the  stated  dis- 
position of  proceeds,  the  financial  condition  of  the  applicant, 
its  resources,  traffic  and  otherwise,  and,  generally,  the  state  of 
its  property,  are  such  as,  in  the  belief  of  the  Commission, 
warrant  certification  that  the  capital  sought  to  be  secured  by 
the  proposed  ....  issue  is  reasonably  required  specifically 
for  one  or  more  of  the  purposes  named  in  the  statute  as  the 
basis  of  future  capitalization."  * 

Most  of  the  considerations  described  in  the  last  part  of 
this  quotation  are  to  be  found  in  the  statute  only  by  implica- 
tion, while  others  represent  questions  bearing  upon  the  exer- 
cise of  discretionary  powers  by  the  Commission,  A  correct 
determination  as  to  these  is  not  only  of  collateral  importance 
but  really  very  essential  to  the  proper  disposition  of  the  case 
in  its  entirety.  Very  early  in  its  work  the  Second  District 
Commission  took  occasion  to  announce  that  in  passing  upon 
an  application  it  would  consider: 

"i.  The  purposes  to  which  the  proceeds  arising  from  the 
sale  of  the  securities  are  to  be  applied. 

2.  The  amount  reasonably  necessary  for  the  consumma- 

tion of  such  purposes. 

3.  The  character  of  the  securities  proposed  to  be  issued. 

4.  Whether  any  proposed  construction  or  extension  is 

likely  to  create  unhealthful  conditions  or  otherwise 
constitute  a  public  nuisance,  infringe  upon  the 
vested  rights  or  impede  the  necessary  operations  of 

«  Matter  of  Erie  R  R.  Co.,  i  P.  S.  C.  Rep.   (.'nd  D.,  N.  Y.)  471   (4S7-48«). 


2C)2  CAPITALIZATION 

other  public  service  corporations,  or  interfere  with 
the  flow  of  water  in  a  navigable  stream  to  the  ex- 
tent of  impairing  its  public  use. 
5.  Whether  there  is  any  reasonable  prospect  of  a  fair 
return  upon  the  investment  proposed,  to  the  end 
that  securities  having  apparent  worth  but  actually 
little  or  no  value  may  not  be  issued  with  our 
sanction."  ^ 

This  list  does  not  exhaust  the  possible  considerations,  for 
every  important  case  will  bring  its  own  individual  problems. 
In  the  words  of  the  New  Jersey  Court  of  Appeals,  it  is  the 
Commission's  duty  to  investigate  not  only  the  object  of 
the  proposed  issue  "but  the  conditions  under  which  it  is  to  be 
made,  and  the  entire  environment  of  the  company  with  its  ante- 
cedents, and  the  prospective  opportunities  it  may  encounter  in 
view  of  its  past  history,  to  meet  the  financial  demands  that  the 
proposed  burden  is  likely  to  impose  upon  it" ;  in  other  words, 
to  pass  upon  "not  only  the  legality  of  the  financial  proposition 
advanced,  but  upon  the  very  merits  of  the  subject  matter  it- 
self from  the  standpoint  of  a  wise  public  pohcy."  ^^ 

§  149.     (3)  Limitations  Upon  Discretionary  Powers  of  Com- 
mission 

While  a  great  deal  of  discretionary  power  must  and  has 
been  allowed  to  commissions,  there  must  also  be  some  point 
where  the  grant  of  authorization  may  be  demanded  as  a  matter 
of  right.  The  statutes  do  not  deny  to  corporations  the  right 
to  issue  stocks  and  bonds;  they  prescribe  the  purposes  for 
which  and  the  conditions  under  which  stocks  and  bonds  may 
be  issued,  and  if  an  applicant  proves  compliance  with  the  law, 
it  becomes  entitled  to  an  order  authorizing  the  issue.  Court 
decisions  in  New  York  and  elsewhere  are  in  harmony  on  this 


»  Matter  of  Hudson  River  Elec.  Pwr.  Corp.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  51   (67). 
10  Interstate   Tel.    &   Tel.    Co.    v.    Public    Utility   Comrs.,   84   N.   J.    L.   Rep.    184;   86, 
Atl.  Rep.  363. 


TASK    OF    PUBLIC    SERVICE    COMMISSIONS         293 

point.  The  Indiana  Supreme  Court  construes  the  statute  "  of 
that  state  as  follows: 

"From  the  provisions  of  this  act  it  is  apparent  that  the 
Public  Service  Commission  is  required  to  hear  and  determine 
the  facts  upon  which  the  application  is  based,  and  the  facts 
thus  determined  constitute  the  foundation  upon  which  its  order 
shall  be  based.  If  the  facts  thus  found  are  such  as  to  entitle 
the  utility  to  a  certificate  of  authority  to  issue  and  sell  bonds 
in  a  given  amount,  it  is  the  duty  of  the  Commission  to  issue 
such  a  certificate.  Under  such  circumstances  the  act  required 
is  ministerial  and  not  discretionary.  To  hold  that  such  act  is 
discretionary  would  enable  the  Commission,  after  the  facts 
were  determined,  to  grant  the  certificate  of  authority  or  to 
withhold  it  at  its  will,  or  to  grant  such  a  certificate  to  one 
public  utility  and  to  withhold  it  from  another  under  the  same 
state  of  facts A  duty  is  none  the  less  ministerial  be- 
cause the  person  who  is  required  to  perform  it  may  have  to 
satisfy  himself  of  the  existence  of  a  state  of  facts  under  which 
he  is  given  his  right  or  warrant  to  perform  the  required 
duty."  '' 

The  Public  Service  Commission  of  Indiana,  referring  to 
its  own  powers  under  that  statute,  states: 

"We  assume  it  to  be  fundamental  that  the  legislature  could 
not,  and  has  not  attempted  to,  grant  to  this  Commission  legis- 
lative powers;  and,  further,  that  the  arbitrary  determination 
that  stocks  and  bonds  may  or  may  not  be  issued  is  the  exer- 
cise of  legislative  power,  and  any  law  which  attempted  to  place 
in  the  hands  of  this  Commission  such  arbitrary  authority 
would  be  unconstitutional.  The  law  creating  the  Public  Ser- 
vice Commission  of  the  State  of  Indiana  stipulates  when  and 
for  what  purposes  a  public  utility  corporation  may  issue  stock 


*' The  statute  reads:  "If  the  Commission  shall  determine  that  such  proposed  issue 
complies  with  the  provisions  of  this  Act,  such  authority  shall  thereupon  be  granted, 
and  it  shall  issue  to  the  public  utility  a  certificate  ef  authority." 

^^  Public  Service  Com.  v.  State  ex  rcl  Merchants  Heat  &  Light  Co.,  184  Ind.  Rep. 
273  (280). 


294 


CAPITALIZATION 


or  bonds,  setting  out  in  detail  the  necessary  conditions  that 
must  exist  before  such  stock  or  bonds  may  be  issued,  and 
then  casts  upon  its  Commission  the  burden  and  duty  of  con- 
ducting an  investigation  to  determine  the  fact  or  facts  in  each 
case,  and  then  provides  that  if  the  facts  which  the  legislature 
provided  must  exist  do  exist,  the  authority  shall  be  granted."  ^' 
There  is  danger,  however,  of  formulating  too  narrow  a 
conception  of  a  commission's  authority.  The  prevailing  rule 
can  be  stated  to  be  that  a  corporation  will  become  entitled  to 
the  execution  of  a  certificate  authorizing  the  issue  of  the  pro- 
posed stock  and  bonds  if  that  proposition  is  brought  within 
the  terms  of  the  statute.  The  commission  must  then  execute 
such  a  certificate  unless  it  can  set  forth  facts  which  prove  the 
proposed  issue  to  be  against  public  policy  or  which  operate  to 
estop  the  corporation  from  demanding  the  execution  of  a  cer- 
tificate as  a  matter  of  right.  The  commission  must  approve 
or  disapprove  of  the  proposition  as  presented  to  it  or  as 
amended  by  the  applicant  in  accordance  with  suggestions  of 
the  commission.  It  may  not,  however,  order  the  issue  of  any 
more  stocks  or  bonds,  or  in  any  different  proportion,  or  for 
any  other  purpose,  or  prescribe  any  other  act  the  authorization 
of  which  must  come  in  the  first  instance  from  the  directors  or 
stockholders  of  the  corporation. 

§  150.     Problem  of  Existing  Overcapitalization 

There  are  many  corporations  whose  present  finances  re- 
flect the  effects  of  practices  which  were  essentially  vicious  or 
which  have  since  come  to  be  regarded  as  improper.  The  situa- 
tion of  these  corporations  presents  a  difficult  problem  to  public 
service  commissions.  Are  these  commissions  called  upon  to 
bring  the  outstanding  capitalization  of  such  corporations  into 
conformity  with  the  principles  which  they  establish  or  apply 
to  capitalization  that  they  authorize  for  issue?  Must  a  com- 
mission seek  to  remedy  the  past  no  matter  how  drastic  the 

•»/n  re  Farmers  &  Merchants  Co-op.  Tel.  Co.,  P.  U.  R.  191S-B,  SS  (sr)- 


TASK   OF   PUBLIC   SERVICE   COMMISSIONS        295 

measures  of  correction  required  for  such  purpose?  Or,  being 
unable  to  remedy  the  past,  should  a  commission  refuse  to 
consider  an  application  for  the  issue  of  additional  stocks  and 
bonds  by  a  corporation  whose  present  financial  condition  is 
the  result  of  past  improper  capitalization?  Regulation  would 
become  prohibition,  if  that  were  done.  Shall  it  not,  then,  turn 
away  from  the  past  and  grant  or  refuse  to  grant  authority 
wholly  upon  a  consideration  of  the  legality,  necessity,  and  pro- 
priety of  the  present  proposed  issue? 

There  is  no  unanimity  in  the  answers  to  the  above  queries. 
How  far  the  powers  and  authority  of  a  commission  can  be  said 
to  be  retroactive  has  been  a  perplexing  question.  These  com- 
missions were  created  to  correct  abuses  well  defined,  and  ample 
powers  have  been  given  them  to  that  end.  There  are  differ- 
ences of  methods  used  in  the  correction  of  human  beings  who 
have  erred  in  their  ways ;  some  need  the  knife  of  a  surgeon  to 
remedy  a  physical  defect,  others  need  instruction;  most  of 
them  need  changed  environment  and  encouragement  to  act 
aright.  There  are  also  differences  in  the  methods  of  correct- 
ing corporations  that  suffer  from  past  maladministration. 

§  151.     (i)  Extent  to  Which  Regulation  May  Be  Retroactive 

The  abuse  most  often  brought  forward  is  overcapitaliza- 
tion. Undoubtedly  it  never  was  intended  to  make  statutes 
retroactive  to  the  extent  of  conferring  power  upon  any  com- 
mission to  order  the  present  capitalization  of  a  corporation  to 
be  pared  down,  simply  because  it  does  not  approve  of  the 
circumstances  and  conditions  under  which  the  stocks  and 
bonds,  or  some  of  them,  were  originally  issued,  or  else  because 
it  considers  the  present  value  of  the  assets  to  be  less  than  the 
par  value  of  the  capitalization  outstanding.  People  will  be 
found,  however,  who  assume  that  this  is  precisely  what  the 
commission  ought  to  do;  such  people  must  have  pressed  their 
theories  upon  the  Railroad  Securities  Commission,  causing 
it  to  make  a  very  emphatic  statement  on  the  subject: 


296 


CAPITALIZATION 


"An  attempt  to  scale  down  old  securities  is  clearly  out  of 
the  question.  Apart  from  the  obvious  constitutional  difficulties 
of  such  a  course,  considerations  of  public  expediency  of  them- 
selves forbid  it.  The  direct  loss  over  the  unsettlement  of  legal 
and  equitable  relations  would  be  very  great.  The  indirect 
loss  from  the  withdrawal  of  confidence  in  American  railroad 
investments  would  be  immeasurable.  Such  a  readjustment 
would  become  archaic  almost  from  the  outset,  because  an  ad- 
justment of  securities  based  upon  the  values  of  today  might 
be  totally  erroneous  tomorrow.  It  would  be  equally  inadvis- 
able, in  cases  where  outstanding  securities  were  in  excess  of 
the  physical  valuation,  to  prohibit  the  issue  of  new  securities 
until  physical  value  had  become  equal  to  the  amount  of  securi- 
ties outstanding;  because  this  principle,  if  generally  applied, 
would  prevent  roads  so  situated  from  securing  the  capital 
needed  for  the  service  of  the  community." 

The  reference  to  constitutional  difficulties  probably  relates 
to  the  provisions  of  the  Federal  Constitution  prohibiting  the 
states  from  passing  laws  or  committing  acts  to  impair  the 
obligations  of  existing  contracts;  obviously  it  would  be  im- 
possible to  remedy  past  abuses  of  capitalization  in  the  manner 
described  without  jeopardizing  the  legal  and  contractual  re- 
lationships of  shareholders,  bondholders,  general  creditors,  or 
of  some  of  them.  The  Federal  Constitution  imposes  no  such  ' 
restriction  upon  the  power  of  the  national  government  and 
federal  legislation  would  not  be  subject  to  this  limitation;  but 
even  though  constitutional  prohibitions  fail  to  restrict  exer- 
cise of  this  power,  undoubtedly  considerations  of  economic 
and  commercial  expediency  would  be  found  to  be  just  as 
restrictive  as  constitutional  prohibitions  in  state  regulation, 

§  152.     (2)  Nature  of  Overcapitalization 

In  discussing  overcapitalization  it  is  necessary  to  hold 
closely  to  definitions.  Overcapitalization  as  a  term  means 
simply  that  the  capitalization  is  greater  than  it  should  be,  but 


TASK    OF    PUBLIC    SERVICE    COMMISSIONS 


297 


the  thing  with  which  it  is  compared  in  arriving  at  the  conclu- 
sion concerning  its  excess  is  not  ahke  in  all  minds.  Some  com- 
pare it  with  the  consideration  actually  received  upon  issue, 
others  with  the  value  which  should  have  been  placed  upon  that 
consideration  in  place  of  the  value  which  was  actually  placed. 
Very  frequently  it  is  compared  with  the  present  value  of  the 
subsisting  assets,  and  not  infrequently  people  will  be  found  to 
charge  overcapitalization  solely  on  the  ground  that  the  earn- 
ings distributed  as  dividends  on  the  stock  are  not  as  great  as 
they  think  they  ought  to  be. 

The  connection  in  which  the  term  is  used  may  sometimes 
indicate  the  specific  meaning  ascribed  to  it.  For  instance,  if 
the  property  is  spoken  of  as  being  overcapitalized,  the  meaning 
should  be  that  there  is  outstanding  an  amount  of  stocks  and 
bonds  greater  than  that  which  the  value  of  the  property  owned 
by  the  corporation  warrants.  If  it  is  the  enterprise  or  the  com- 
pany which  is  spoken  of  as  overcapitalized,  the  meaning  should 
be  that  the  amount  of  outstanding  capitalization  is  greater 
than  the  earnings  warrant.  It  will  be  noted  that  this  last  situa- 
tion may  also  exist  where  the  actual  investment  has  been 
greater  than  necessary  and  where  a  smaller  investment  would 
have  produced  the  same  amount  of  earnings. 

It  is  not  sufficiently  understood  that  it  makes  a  great  deal  of 
difference  whether  the  overcapitalization  is  based  upon  the 
amount  of  stock  and  bonds  together,  or  upon  the  amount  of 
the  one  or  the  other  alone.  Overcapitalization,  so  far  as  it 
represents  a  danger  in  and  of  itself,  wholly  apart  from  the 
fact  that  it  may  be  made  the  means  of  misrepresentation  in 
the  hands  of  unscrupulous  people,  is  a  device  of  inflated  credit ; 
that  is  to  say,  its  existence  will  signify  that  there  is  outstand- 
ing an  aggregate  claim  against  wealth  which  is  greater  than  the 
wealth  itself.  Bonds  and  other  forms  of  indebtedness  repre- 
sent a  claim  against  wealth ;  capital  stock  is  evidence  of  posses- 
sion of  the  wealth. 

Take  the  case  of  a  corporation  which  Is  making  its  original 


298 


CAPITALIZATION 


issue  of  capital  stock,  no  bonds  being  utilized  in  the  financing. 
If  it  sells  the  stock  at  par,  each  share  will  represent  an  interest 
of  value  equal  to  the  par;  if  the  stock  is  sold  at  a  discount, 
each  share  will  represent  a  value  which  is  simply  a  proportion- 
ate amount  of  the  aggregate  amount  received  from  the  sale  of 
the  stock;  if  it  is  issued  in  exchange  for  property,  each  share 
will  represent  a  proportionate  part  of  the  value  of  that  prop- 
erty whatever  that  value  is  found  to  be.  Let  some  time  elapse, 
and  take  the  same  company's  situation ;  its  capital  stock  repre- 
sents simply  the  value  of  the  existing  assets.  A  discrepancy 
will  be  found  only  if  one  compares  the  par  value  with  the 
actual  value  of  the  stock,  but  why  should  this  confusion  of 
the  nature  of  things  cause  a  charge  of  defective  financing 
against  the  corporation? 

The  trouble,  of  course,  lies  in  the  fact  that  because  of  the 
par  value  expressed  or  for  other  reasons,  people  will  be  found 
who  will  place  a  value  upon  the  shares  of  stock  in  excess  of 
real  value,  and  will  give  or  advance  money  on  the  shares  ac- 
cordingly; thus,  indirectly,  there  will  be  created  claims  against 
wealth  exceeding  in  amount  the  value  of  the  wealth.  The 
corporation,  however,  is  not  a  party  to  the  transaction,  al- 
though it  may  be  indirectly  responsible  if  the  misrepresenta- 
tion of  value  arises  from  an  incorrect  or  exaggerated  state- 
ment of  its  financial  situation. 

Suppose  this  same  corporation  finances  its  project  out  of 
the  issue  of  bonds,  giving  the  stock  as  bonus.  Obviously  the 
stock  has  no  value  because  it  does  not  evidence  the  possession 
of  wealth.  If,  moreover,  in  consideration  for  the  issue,  prop- 
erty other  than  cash  was  accepted  at  an  overvaluation,  over- 
capitalization must  result.  Or,  again,  even  if  the  issue  had 
been  made  for  full  value  and  thereafter  continued  operations 
at  a  loss  have  caused  the  capital  to  be  impaired,  overcapitali- 
zation will  likewise  result.  But  take  the  more  usual  situation 
where  both  bonds  and  stock  are  issued,  each  for  substantial 
consideration,  and  unprofitable  operations  thereafter  impair 


TASK    OF    PUBLIC    SERVICE    COAIMISSIONS 


299 


the  capital:  overcapitalization  will  not  result  as  long  as  the 
capital  stock  alone  can  absorb  the  loss.  Not  until  after  the 
stockholders'  equity  has  been  completely  wiped  out  will  there 
arise  the  situation  of  outstanding  claims  against  wealth  ex- 
ceeding in  amount  the  wealth  itself. 

As  long  as  the  stockholders  continue  to  have  any  equity  at 
all,  a  charge  of  overcapitalization  must  mean  that  the  par 
value  of  the  outstanding  stock  is  greater  than  the  value  of  the 
equity.  Of  what  use  can  it  be  to  make  an  adjustment  of  the 
outstanding  capitalization  so  that  the  value  of  the  outstanding 
shares  may  equal  par?  Moreover,  how  is  the  value  of  the 
equity  to  be  measured,  in  view  of  the  difficulties  described  else- 
where (§  168)  as  standing  in  the  way  of  placing  a  value  upon 
the  capital  utilized  in  a  public  service  business?  Even  if  a 
value  were  arrived  at,  how  could  it  be  thereafter  maintained? 
The  most  serviceable  measure  of  value  is  that  which  reflects 
the  earning  power,  and  earning  power  is  usually  the  measure 
of  corporate  credit  as  well. 

§  153-     (3)  Regulation  of  Accounts  a  Corrective  Measure 

Under  the  circumstances  stated  above,  to  what  extent 
should  a  commission  seek  to  remedy  alleged  overcapitali- 
zation? It  was  noted  that  the  corporation  becomes  indirectly 
responsible  for  some  of  the  evils  resulting  from  misrepresenta- 
tion of  real  value  of  the  stock  if  the  misstatement  of  its  own 
accounts  causes  that  misrepresentation.  To  a  great  extent, 
then,  the  evils  of  alleged  overcapitalization  can  be  corrected 
through  regulation  of  the  accounts.  If  the  assets  are  insuffi- 
cient to  take  care  of  the  liabilities,  the  accounts  will  show  it; 
if  dividends  have  been  improperly  distributed,  if  stocks  and 
bonds  have  been  issued  for  other  than  proper  purposes  or  for 
inadequate  consideration,  the  accounts  should  reflect  the  situa- 
tion if  they  have  been  properly  kept.  The  state  commissions, 
and  the  Interstate  Commerce  Commission  as  well,  have  been 
given  very  broad  powers  in  regulating  accounts  and  in  en- 


300 


CAPITALIZATION 


forcing  a  true  statement  of  the  financial  affairs  of  the  corpora- 
tions under  their  jurisdiction.  In  the  control  over  the  ac- 
counts, therefore,  the  commission  has  one  very  effective 
method  of  satisfying  all  proper  public  demands  in  this  respect. 
If  more  drastic  correction  is  required,  it  should  be  achieved 
through  means  and  under  legislation  other  than  those  relating 
to  the  powers  of  these  commissions.  The  question  of  retro- 
active effect  of  commission  orders  is  not  involved;  an  order 
that  the  accounts  be  written  and  facts  properly  set  forth  will, 
of  course,  relate  to  the  statement  of  past  transactions,  but  it 
will  represent  a  very  proper  exercise  of  the  commission's 
powers.  And  yet,  here  also  the  commission  must  consider 
its  obligation  to  protect  established  credits;  if  the  net  effect  of 
rewriting  the  accounts  will  be  to  place  in  jeopardy  the  con- 
tinuance of  the  corporate  enterprise  and  its  legitimate  exten- 
sion, justice  must  be  tempered  with  mercy.  An  understanding 
may  be  reached  as  to  accounting  procedure  which  will  in  due 
course  of  time  and  without  undue  disturbance  rectify  the  errors 
of  the  past.  It  goes  without  saying  that  the  corporation  must 
show  absolute  good  faith  both  in  collecting  the  facts  of  past 
transactions  and  in  willingness  to  correct  the  mistakes. 

An  examination  of  the  accounts  must  be  very  thorough  if 
orders  for  rewriting- are  to  be  based  thereupon.  Such  an  ex- 
amination will  necessarily  involve  considerable  expense  and 
much  of  the  time  both  of  experts  employed  by  the  commission 
and  of  the  commissioners  themselves,  as  well  as  of  the  cor- 
poration's staff.  Hence,  although  the  commission  always  has 
the  power  to  order  an  examination,  such  a  task  is  seldom  under- 
taken unless  the  issue  is  specifically  raised.  It  is  sometimes 
done  in  rate  cases,  but  more  often  in  the  consideration  of  ap- 
plications for  authority  to  issue  additional  stocks  and  bonds. 
The  commission  may  then  insist  that  the  accounts  be  cor- 
rected before  authorization  is  granted,  so  that  the  public 
may  have  an  accurate  statement  from  which  to  draw  its  con- 
clusions as  to  the  value  of  the  securities  which  it  shall  author- 


TASK    OF    PUBLIC    SERVICE    COMMISSIONS 


30 1 


ize,  A  situation  requiring  such  disposition  was  described  by 
the  New  York  Commission  as  follows: 

"This  company  seeks  to  obtain  money  by  the  sale  of  bonds 
and  stock  at  a  time  when  its  accounts  are  untrue  to  a  very 
large  and  material  amount.  The  value  of  such  stock  and 
bonds  is  in  very  great  measure  to  be  determined  by  the  truth- 
fulness of  those  accounts.'  No  one  can  determine  whether  to 
invest  in  these  securities  without  relying  upon  those  accounts. 
Knowing  the  facts,  it  would  be  impossible  for  the  Commission 
to  justify  itself  in  allowing  these  securities  to  be  placed  upon 
the  market  to  be  sold  upon  the  faith  which  the  buyer  must 
repose  in  the  correctness  of  the  company's  balance  sheet."  " 

The  Commission  in  this  case  is  not  seeking  justification  for 
withholding  consent  to  the  issue  of  additional  securities  on 
the  ground  that  overcapitalization  is  apparent,  but  rather  that 
the  accounts  are  incorrect,  and  that  the  corporation,  if  it  did 
not  amend  its  accounts  prior  to  the  issue  of  additional  securi- 
ties, would  be  presenting  to  the  possible  investor  a  false  state- 
ment of  its  assets  and  liabilities,  that  is  to  say,  it  would  mis- 
represent its  credit.  Even  in  such  a  case  as  this,  however, 
the  problem  cannot  be  solved  by  merely  withholding  consent, 
for  the  situation  may  be  such  as  to  call  for  affirmative  action 
if  the  business  is  to  be  continued.  Regulation,  if  it  is  to  be 
worth  while  and  successful,  must  be  a  positive,  not  always 
a  negative,  force ;  it  must  be  permissive  as  well  as  restrictive. 

§  154.     (4)  Overcapitalization  Need  Not  Bar  Proper  Stock 
and  Bond  Issues 

There  are,  of  course,  cases  where  overcapitalization  has 
been  wilful,  caused  by  the  acceptance  of  property  at  an  over- 
valuation or  the  issue  of  securities  for  inadequate  consideration. 
Such  transactions,  however,  have  been  carried  out  under  color 
of  the  law;  for  instance,  pursuant  to  the  statutory  declaration 


^*  Matter  of  Binghamton  Light,  Heat  &  Power  Co.,  3  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.) 
X71  (aoa). 


202  CAPITALIZATION 

that  the  judgment  of  the  directors  as  to  the  value  of  property 
received  shall  be  conclusive.  To  question  these  acts  long  after 
their  occurrence,  or  to  base  formal  action  concerning  pending 
application  upon  a  judgment  as  to  the  impropriety  of  these 
transactions,  w^ould  be  a  dangerous  exercise  of  authority. 

The  effect  of  statutory  requirements  limiting  capitalization 
to  certain  ratios  of  assets,  such  as  the  Texas  statute  which 
limits  the  issue  of  stocks  and  bonds  "at  no  time  to  be  more 
than  50  per  cent  over  the  value  of  the  whole  property  and 
franchises,"  is  to  hold  the  Commission  to  the  strict  rule  that 
additional  capitalization  may  be  authorized  only  where  the 
entire  authorized  capitalization  (i.e.,  that  already  outstanding 
and  that  to  be  issued)  bears  a  proper  relation  to  the  value  of 
all  the  properties  then  possessed  or  to  be  acquired  through  the 
proceeds  of  the  new  issues.  The  experience  of  that  state  under 
this  statute  has  not  been  such  as  to  invite  other  states  to  the 
enactment  of  similar  statutes. 

Very  early  in  its  work  the  New  York  Public  Service  Com- 
mission for  the  Second  District  had  to  consider  an  application 
for  the  issue  of  additional  securities,  which  was  being  op- 
posed by  city  officials  upon  the  ground  that  the  company  was 
already  very  much  overcapitalized,  in  proof  or  disproof  of 
which  assertion  they  asked  for  a  careful  valuation  of  the 
property  of  the  corporation.  This  request  of  the  city  was 
denied  by  the  Commission,  which  announced  that  it  would  not 
inquire  into  any  alleged  overcapitalization  and  that  its  investi- 
gation into  the  merits  of  the  company's  application  would  be 
confined  "to  the  question  whether  such  capitalization  should 
be  authorized  by  reason  of  the  actual  investment  of  money  for 
the  purposes  of  the  corporation  recognized  by  law  as  a  subject 
of  capitalization."  It  said:  "The  question  as  to  the  possible 
overcapitalization  of  the  company  is  an  interesting  one;  but  it 
does  not  seem  to  the  Commission  to  have  any  direct  bearing 
upon  the  application  before  it."    Moreover — 

"To  hold  up  needed  improvements  in  a  case  like  this,  while 


TASK    OF    PUBLIC    SERVICE    COMMISSIONS         303 

the  exact  condition  of  the  corporation  is  investigated  and  the 
value  of  its  capitaHzation  determined,  would  be  undesirable. 
The  Commission  might  become  involved  in  endless  complica- 
tions which  would  tend  to  defeat  the  very  purpose  of  its  exist- 
ence ;  and  improvements  needed  for  the  efficiency  of  public 
service  might  be  held  up,  while  the  facts  as  to  a  matter  were 
ascertained  which,  however  interesting  and  valuable  in  them- 
selves, would  not  help  the  Commission  in  the  least  as  to  de- 
ciding the  point  at  issue.  The  past  of  a  corporation,  whether 
financially  faulty  or  blameless,  should  not  bar  the  way  to  its 
rendering  efficient  service  in  the  present  or  future."  ^^ 

§  155.  Financial  Record  and  Status  of  Applicant  to  Be  Con- 
sidered 
While  the  Commission  will  not  pass  upon  overcapitalization 
alleged  to  exist  because  of  discrepancy  between  the  value  of 
the  existing  assets  and  the  outstanding  stocks  and  bonds,  the 
financial  record  of  a  corporation  seeking  additional  capital  is 
a  matter  on  which  the  Commission  is  bound  fully  to  inform 
itself,  especially  where  the  corporation  has  not  always  been 
subject  to  regulation.  There  is  described  elsewhere  (see  Chap- 
ter XVI)  the  not  uncommon  expedient  of  issuing  additional 
securities  to  purchase  equipment  or  other  items  of  fixed  capi- 
tal for  the  replacement  of  units  which  have  been  retired  but 
which  continue  to  be  carried  in  the  accounts  as  though  still  in 
service.  The  purpose  is  very  evident ;  since  the  liabilities  would 
be  increased  by  the  amount  of  the  new  issue,  it  is  necessary  to 
increase  the  assets  also  by  the  amount  of  the  new  capital 
acquired,  which  will  therefore  be  shown  as  an  addition,  while 
actually  the  assets  were  not  increased  at  all,  or  perhaps  in- 
creased only  by  the  difiference  between  the  cost  of  the  old  and 
the  new  capital.  In  these  instances  only  the  most  careful  in- 
vestigation will  reveal  the  fact  that  securities  proposed  to  be 
issued  ostensibly  for  proper  corporate  purposes  are  in  reality 

"  Matter  of  Watertown  Light  &  Power  Co.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  146  (15S). 


304  CAPITALIZATION 

to  reimburse  the  corporation  for  operating  expenses — a  very 
improper  purpose  and  clearly  effecting  gross  overcapitalization. 

Moreover,  the  financial  record  of  an  applicant  will  prove 
a  valuable  index  to  the  character,  ideals,  and  efficiency  of  the 
management,  on  which  there  may  be  based  an  estimate  as  to 
the  probable  success  of  a  new  venture.  It  may  also  prove  de- 
cisive as  to  the  character  of  the  securities  to  be  issued;  it  may 
be  that  the  proportion  of  bonds  to  stock  is  too  great  and  the 
proposed  financing  should  be  confined  to  capital  stock  issues  to 
restore  the  bondholders'  margin  of  security  and  to  hold  down 
fixed  charges  so  as  to  lessen  the  possibility  of  such  financial 
embarrassment  as  has  very  often  been  the  source  of  tempta- 
tion for  much  of  the  corporate  "high  finance."  Or,  again,  it 
may  be  that  on  the  basis  of  that  record  future  financing  wall 
be  limited  to  temporary  expedients  until,  by  a  process  of  with- 
holding dividends  and  putting  earnings  back  into  the  property, 
the  corporation  re-establishes  its  credit  so  that  long-term  securi- 
ties may  be  issued  without  the  necessity  of  heavy  discounts  or 
extra-high  rates  of  interest. 

It  will  not  be  possible,  neither  would  it  be  desirable,  always 
to  require  a  thorough  inquiry  into  all  the  details  of  past  finan- 
cial practices,  the  state  of  the  accounts,  and  the  condition  of 
corporate  affairs.  Every  commission  will  at  times  face  Kmi- 
tations  upon  time  and  capacity  which  will  be  controlling,  and 
to  adopt  a  rule  that  such  procedure  must  be  followed  in  every 
case  would  work  hardship  in  many  instances  where  the  need 
for  new  capital  is  pressing  and  imperative.  The  purposes  of 
the  proposed  issue,  the  relative  increase  to  be  effected  in  total 
capitalization,  and  other  incidents  of  the  application  before 
the  commission,  will  have  to  be  considered  In  passing  upon 
the  need  for  such  a  thorough  inquiry. 

§  156.     Paramount  Duty  of  Commission 

It  must  never  be  forgotten  that  the  greatest  responsibility 
of  a  commission  in  the  exercise  of  its  regulative  powers  is 


TASK    OF    PUBLIC    SERVICE    COxMMISSIONS 


305 


that  of  assuring  the  continuity  of  the  service  rendered  by  the 
pubhc  utiHties.  The  commission  may  become  interested  in 
the  consideration  of  the  moral  niceties  of  past  transactions,  it 
may  be  convinced  of  imprudence,  mismanagement,  inexperi- 
enced financing  or  what  not,  as  indicated  by  the  record  before 
it.  The  real  question  which  must  be  determined,  however,  is 
how  best  to  assure  the  continuity  of  the  enterprise,  considering 
its  history  and  its  conditions  and  needs.  If  the  historical 
record  of  each  corporation  were  to  be  arbitrarily  used  against 
it,  many  public  utilities  would  find  all  doors  for  expansion  and 
growth,  and  every  possibility  of  living  down  the  past,  as  it 
were,  closed  before  them.  The  only  alternative  open  to  them 
would  be  that  of  dragging  along  with  poor  facilities  and  in- 
creasingly poor  service,  or  going  into  bankruptcy.  The  first 
situation  is  highly  undesirable  from  every  standpoint;  the 
second  is  inequitable  in  that  it  penalizes  the  present  security 
holders  for  all  the  mistakes,  innocent  or  wilful,  of  the  past 
owners  by  takfng  the  property  out  of  their  hands  and  trans- 
ferring it  to  others  at  the  low  cost  necessarily  involved  in  a 
forced  sale  under  such  conditions,  while  giving  the  new  owners 
complete  freedom  in  financing  the  improvement  and  expansion 
of  their  plant  to  render  operations  more  profitable.  It  must 
not  be  forgotten  that  practices  which  today  may  be  considered 
improper,  may  at  the  time  of  their  use  have  been  considered 
as  being  eminently  proper  and  expedient  to  a  compelling  degree. 
In  the  pioneer  days  of  many  classes  of  public  utilities  a  great 
many  matters  which  today  are  subject  to  rule  and  classification 
were  then  merely  matters  of  guess  and  experiment.  Each 
man's  guess  was  different  from  that  of  all  others;  each  had  his 
own  theory  and  carried  on  his  own  experiments. 

It  is  just  such  a  situation  as  that  described  above  which 
was  referred  to  by  Mr.  Hemans  of  the  Michigan  Commission 
in  discussing  before  the  National  Association  of  Railway 
Commissioners  ^^  a  committee  report  which  had  expressed  the 

'"  Proceedings  of  1913  Convention,  page  :3s. 


3o6  CAPITALIZATION 

relative  desirability  of  corporate  bankruptcy  as  against  the 
abandonment  of  the  strict  theory  that  the  present  situation  of 
a  corporation  and  its  record  should  be  conclusive  against  an 
application  to  issue  additional  stocks  and  bonds: 

"If  the  report  of  the  Committee  means  to  say  that  it  is  bad 
practice,  under  all  conditions  and  circumstances,  to  allow  a 
utility  which  has  become  indebted  over  and  above  the  amount 
of  its  stock  and  bonds  to  issue  further  securities,  I  do  not  wish, 

by  my  silence,  to  seem  to  acquiesce  in  that  proposition 

I  submit  that  there  are  conditions  under  which  a  commission 
is  justified  in  allowing  the  issuance  of  securities  under  such 
circumstances. 

"I  quite  heartily  agree  with  the  Chairman  of  the  Com- 
mittee when  he  says  that  the  public  is  not  interested  in  the 
question  as  to  who  furnishes  the  service.  That  is  very  true; 
but  when  that  service  has  been  the  result  of  the  best  knowledge 
possessed  by  the  organization  under  all  the  circumstances,  and 
a  loss  has  developed  through  an  inadequate  rate  because  of  a 
lack  of  knowledge  of  the  conditions  that  should  apply,  or  when 
that  loss  has  resulted  through  an  inefficient  and  destructive 
competition,  or  through  stress  of  financial  conditions  over 
which  the  utility  has  no  control,  then  I  submit  that  the  Com- 
mission of  which  I  am  a  member  would  feel  justified  in  allow- 
ing that  utility,  which  has  been  honestly  and  efficiently  con- 
ducted, to  sell  its  securities  if  possible.  In  other  words,  I 
believe  that  instead  of  a  hard  and  fast  rule,  which  I  under- 
stand the  committee  to  recommend,  the  only  rule  that  can  be 
enforced  in  practical  affairs  is  the  rule  of  the  exercise  of  a 
wise  discretion. 

"The  Michigan  law  provides  that  the  Commission  shall 
find  that  the  securities  are  reasonably  required  for  the  purposes 
of  the  organization,  and  under  that  broad  grant  of  power  the 
Michigan  Railroad  Commission  attempts  to  say  what  is  reason- 
able in  each  particular  case;  and  we  submit  that  you  cannot 
make  a  hard  and  fast  rule,  and  say  that  every  utility  which  by 


TASK   OF   PUBLIC    SERVICE    COMMISSIONS         307 

stress  of  conditions  that  could  not  be  foreseen  has,  in  a 
measure,  impaired  the  capital,  should  go  into  the  hands  of  a 
receiver.  It  is  true  that  the  consumer  is  not  interested  in  the 
question,  who  furnishes  the  service ;  but,  so  long  as  we  believe 
in  the  private  ownership  of  utilities,  so  long  as  we  invite  the 
investment  of  capital  to  furnish  the  utilities  that  the  public 
enjoy,  while  the  public  may  not  be  interested  in  the  question, 
who  furnishes  the  service,  I  insist  that  the  public  are  vitally 
interested  in  the  integrity  of  the  investment  of  the  man  who 
puts  his  money  in  and  risks  the  conditions  that  may  overcome 
the  utility. 

"Thirty  years  ago  men  invested  their  money  in  the  tele- 
phone utilities,  with  no  one  to  blaze  the  pathway  over  which 
they  were  to  travel.  They  did  not  know  the  amount  that 
should  be  charged  for  depreciation.  They  did  not  know  what 
were  adequate  rates;  and  many  a  corporation  was  near  to 
bankruptcy  because  it  was  traveling  an  unknown  path.  I 
submit  that  it  is  the  part  of  wisdom,  if  conditions  of  that  kind 
are  repeated,  and  a  loss  is  brought  about,  because  of  condi- 
tions over  which  the  men  who  have  acted  honestly  and  as 
efficiently  as  they  knew  how  have  had  no  control,  it  is  the  part 
of  wisdom  for  the  Commission  to  allow  a  utility  corporation, 
under  such  circumstances,  to  issue  further  securities.  I  think 
the  Commission  should  be  governed  by  a  wise  discretion." 

It  goes  without  saying  that  above  all  things  the  commission 
must  exercise  the  greatest  care  to  base  its  own  acts  and  authori- 
zation on  absolutely  sound  principles,  and  then  to  see  that  its 
orders  are  faithfully  carried  out,  so  that  the  corporations 
growing  up  under  its  guidance  and  protection  may  be  kept  free 
of  corruption  and  saved  from  the  abuses  and  mistakes  which 
have  heretofore  jeopardized  many  public  service  corporations. 


CHAPTER   XV 

COLLATERAL  ASPECTS  OF  REGULATING  STOCK 
AND  BOND   ISSUES 

An  enumeration  of  the  matters  within  the  jurisdiction  of 
the  public  service  commissions  was  given  in  Chapter  II, 
and  it  was  there  explained  that  in  studying  the  regulation  of 
capitalization  it  would  be  necessary  to  give  some  attention  to 
other  aspects  of  regulation  because  of  their  intimate  connec- 
tion with  the  subject  in  hand.  Some  of  these  have  been 
touched  upon  incidentally  in  the  foregoing  pages,  and  this 
chapter  takes  up  a  brief  discussion  of  the  more  important 
matters  of  collateral  interest. 

§  157.     Control  Over  New  Enterprises 

The  existence  in  one  community  of  two  or  more  public 
utilities  means  the  duplication  of  plant  and  the  division  of 
business.  Each  must  construct  its  own  plant,  erect  its  own 
pole  lines,  lay  down  its  own  conduits,  and  undertake  whatever 
other  construction  may  be  needed  to  carry  on  its  enterprise; 
each  at  best  will  get  only  a  portion  of  the  business  which  the 
community  can  give.  In  other  words,  the  capital  invested  is 
multiplied  while  the  volume  of  business  in  the  community  re- 
mains the  same.  Such  competition  will  not  long  prevail  be- 
tween two  companies;  it  will  not  be  long  before  they  will  find 
it  to  their  interest  and  advantage  to  merge  their  separate  enter- 
prises. The  merger,  however,  while  rendering  possible  a  uni- 
fication of  the  operations,  cannot  restore  to  the  investors  the 
capital  committed  to  an  unnecessary  plant. 

To  prevent  the  preliminary  stage  of  ruinous  competition 
and  to  lend  stability  to  the  enterprises  which  have  become 

308 


COLLATERAL  ASPECTS  OF  REGULATION 


309 


established,  public  policy  demands  that  regulating  commis- 
sions shall  have  the  power  to  guarantee  to  corporations 
freedom  from  competition  so  long  as  these  corporations  ade- 
quately serve  the  public  and  meet  the  requirements  imposed 
upon  them. 

Chapter  II  described  how  state  governments  introduced 
unrestrained  incorporation  and  free  competition,  by  abandon- 
ing the  system  of  incorporation  by  special  act,  without  at  the 
same  time  providing  any  other  method  of  control  over  new 
corporations;  also  how  the  disastrous  effects  of  rate  wars  and 
irresponsible  competition  forced  the  states  later  on  to  reassert 
some  measure  of  regulation,  mainly  through  boards  of  rail- 
road commissioners.  When  the  New  York  Board  of  Railroad 
Commissioners  was  first  organized  in  1883  it  could  exercise 
no  control  whatever  over  the  entrance  of  new  corporations 
into  the  field,  while  the  general  corporation  laws  continued  to 
extend  the  great  measure  of  latitude  in  this  respect  which  had 
prevailed  since  1850.  In  its  first  annual  report  this  Commis- 
sion said: 

"It  is  the  general  opinion  that  the  time  has  now  come  when 
the  State  ought  to  supervise  such  proceedings"  (i.e.,  those 
preliminary  to  incorporation)  "and  more  carefully  exact  com- 
pliance with  preliminary  conditions,  as  well  as  to  insist  that 
before  the  right  of  eminent  domain  is  vested  in  a  railroad  cor- 
poration there  shall  exist  a  reasonable  public  demand  and 
necessity  for  the  road  proposed  to  be  constructed." 

In  its  next  annual  report  (1884)  the  Board  described  the 
following  very  interesting  situation: 

"A  war  of  rates  has  broken  out,  of  which  at  this  writing 
no  one  can  see  the  outcome.  It  looks  as  if  the  struggle  for 
existence  had  begun,  of  which  the  result  will  be  the  survival 
of  the  fittest,  the  financial  death  of  others,  with  its  attendant 
distress  and  loss  of  property.  In  the  month  of  June  the  New 
York,  West  Shore  and  Buffalo  Railway  Company  went  into 
the  hands  of  a  receiver The  receivers  of  the  property 


3IO 


CAPITALIZATION 


being  under  obligations  alone  to  earn  operating  expenses,  and 
with  the  hope  of  increasing  the  business  by  a  radical  reduction, 
about  the  20th  of  October  reduced  the  rates  to  the  un- 
precedented figure  of  one  cent  per  mile  for  the  transportation 
of  passengers.  A  corresponding  reduction  was  made  in  freight 
charges.  These  rates  have  been  met  by  the  New  York  Central 
and  Hudson  River  Railroad  Company.  It  is  needless  to  dwell 
upon  the  demoralization,  fluctuations,  and  loss  incident  to  such 
a  condition  of  affairs  as  the  above. 

"It  is  urged  that  one  lesson  to  be  drawn  is  the  lack  of 
wisdom  on  the  part  of  the  State  of  permitting  any  thirteen 
men  who  can  secure  subscriptions  of  $10,000  per  mile,  with 
ten  per  cent  thereof  paid  in,  to  build  a  railroad  anywhere  they 
see  fit  without  an  expression  from  the  State  of  the  public 
exigency  for  the  same. 

"A  railroad  cannot  be  built  without  the  State  delegating  to 
its  promoters  the  highest  power  it  possesses  over  property: 
the  right  of  eminent  domain;  the  right  to  take  private  prop- 
erty for  public  uses.  The  State  itself  never  exercises  this 
sovereign  power  except  in  cases  of  public  necessity.  Why 
should  it  thus  delegate  it  to  any  thirteen  men  to  be  exercised 
for  mere  private  gain,  frequently  at  the  expense  of  vested 
rights  and  grave  public  interests? 

"When  the  State  has  undertaken  the  control  of  railroads 
by  the  creation  of  supervisory  boards,  and  has  determined  to 
exact  the  highest  standard  of  service  at  reasonable  rates  of 
freight  and  fare,  it  would  certainly  seem  as  if  a  corresponding 
obligation  rested  upon  it  to  protect  existing  railroads  from 
useless  and  disastrous  competition  by  unnecessary  new  ones. 
It  was,  with  these  ideas  in  view,  that  the  majority  of  the  Board 
made  the  recommendation  for  the  amendment  of  section  2, 
chapter  140,  of  the  laws  of  1850,  in  its  supplementary  report 
to  the  legislature  of  last  year,  which,  however,  did  not  meet 
with  favor  from  that  honorable  body." 

Acceding  to  the  repeated  requests  of  the  Commission,  the 


COLLATERAL  ASPECTS  OF  REGULATION 


311 


legislature  finally  amended  the  railroad  laws  in  1892 — 42  years 
after  it  had  opened  the  door  to  unrestrained  railroad  competi- 
tion. The  effect  of  the  amendment  is  thus  described  in  the 
report  of  the  Board  of  Railroad  Commissioners  for  that  year: 
"The  Railroad  Law  of  1892  imposes  new  duties  and  re- 
sponsibilities upon  the  Board  of  Railroad  Commissioners,  the 
most  notable  of  which  reverses  the  policy  of  the  State  touch- 
ing railroad  extension,  a  policy  which  has  prevailed  since  1850. 
In  that  year,  under  the  influence  of  public  opinion,  all  en- 
couragement that  could  be  given,  in  the  law,  was  extended  to 
proposed  investors.  The  policy  then  adopted  has  had  a  great 
influence  upon  the  development  of  the  state,  but  in  the  course 
of  years  abuses  have  crept  in;  railroads  have  been  projected 
and  built  upon  parallel  and  competing  lines,  which  had  no 
purpose  but  to  compel  older  and  established  lines  to  buy  the 
property  of  the  rival  or  to  sell  their  own.  For  a  time  these 
projects  were  looked  upon  with  equanimity,  as  it  was  believed 
that  such  competition  benefited  the  community  through  which 
the  road  passed  by  lowering  rates,  but  it  was  discovered  that 
such  belief  was  fallacious.  Unequal  and  unstable  rates  fol- 
lowed from  the  contests  between  the  companies,  which  ended 
either  in  an  agreement  for  higher  rates  or  in  the  absorption  of 
one  company  by  the  other,  with  the  consequence  of  establishing 
higher  rates  permanently  to  support  two  constructions  and 
equipments  where  one  had  sufficed.  In  the  end  communities 
were  the  sufferers;  the  day  when  the  legislature  could  interfere 
and  lower  rates  be  made  was  postponed  indefinitely.  Other 
evils  followed,  such  as  niggardly  economy  in  maintenance  and 
in  service,  until  public  opinion  demanded  a  restraint  upon  rail- 
road building  and  extension.  This  restriction  is  expressed  in 
section  59  of  the  Railroad  Law  of  1892,  whereby  the  consent 
of  the  Board  of  Railroad  Commissioners  to  the  building  of  a 
road  is  a  condition  precedent  to  beginning  an  enterprise.  The 
consent  or  withholding  the  consent  on  the  part  of  the  Board 
is  made  reviewable  by  the  courts.    In  short,  the  State  has  de- 


212  CAPITALIZATION 

termined  to  reverse  its  policy  of  the  past  by  insisting  that  a 
pubHc  necessity  shall  be  declared  before  further  lines  of  rail- 
road shall  be  built." 

In  1895  the  scope  of  the  amendment  was  extended  to  take 
in  street  railways.  In  1905  an  act  establishing  the  Commission 
of  Gas  and  Electricity  provided  for  a  certificate  of  authority 
to  be  procured  before  a  gas  or  electric  company  could  exercise 
any  power  or  transact  any  business  in  the  state.  All  of  these 
provisions  have  been  substantially  carried  into  the  Public 
Service  Commissions  Law;  the  laws  of  other  states  contain 
similar  provisions,  and  the  history  of  progress  of  regulation 
in  those  states  has  been  much  the  same  as  that  here  described 
for  New  York  State. 

§  158.     (i)  Duplication  of  Plants  to  Be  Avoided 

This  record  of  legislation,  indicating  "an  extension  of 
policy  progressing  uniformly  in  one  direction,  has  great  sig- 
nificance." ^  The  necessity  which  compelled  the  adoption  of 
the  policy  and  shaped  its  development  suggests  the  principles 
which  control  its  application.  "These  laws  were  unquestion- 
ably enacted  for  the  purpose  of  prohibiting  some  public  evil, 
to  prevent  results  which  experience  had  demonstrated  to  be 
injurious  to  the  public.  It  is  therefore  incumbent  to  know 
precisely  what  evils  were  sought  to  be  prevented  by  these  enact- 
ments, and  what  the  Commission,  if  it  fairly  and  justly  exer- 
cises the  powers  conferred  upon  it,  must  guard  against. 

"It  is  not  possible  to  mistake  the  situation.  The  history  of 
the  past  fifty  years  is  full  of  warnings  and  replete  with  ex- 
periences which  the  deliberate  judgment  of  the  lawmaking 
body  of  the  State,  reinforced  by  public  sentiment,  has  sought 
to  avert.  The  evil  is  the  unnecessary  duplication  of  public 
utilities."  ^ 


'Matter  of  Buffalo,  Rochester  &•  Eastern  R.  R.  Co.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.) 
5.31a  (542).  This  opinion  contains  a  very  excellent  discussion  and  most  of  the  material 
for  this  resume  has  been  obtained  from  it. 

'  Id.,  page  543- 


COLLATERAL  ASPECTS  OF  REGULATION      313 

The  project  of  a  new  public  service  corporation  afifects  the 
interests  of  three  separate  groups:  first,  that  of  the  owners  of 
the  new  project;  second,  that  of  the  community  proposed  to  be 
served ;  and  third,  the  owners  of  a  similar  project  already  serv- 
ing that  community.  It  can  safely  be  assumed  that  the  first 
two  groups  will  act  in  concert  and  usually  against  the  third, 
but  neither  the  unanimity  in  desire  of  the  two  nor  the  objection 
of  the  other  can  be  made  controlling  as  to  the  admission  of 
the  new  corporation. 

"The  legislature  has  determined  that  the  fact  that  parties 
or  corporations  are  willing  to  undertake  the  proposed  enter- 
prise and  put  in  their  own  money  or  the  money  of  others  is 
not  sufficient  alone  to  justify  permission  to  engage  in  the  work. 
For  forty-two  years  the  public  and  the  legislature  did  deem 
such  willingness  sufficient  and  the  law  stood  upon  the  statute 
books  accordingly.  For  reasons  entirely  satisfactory,  based 
upon  a  long  experience,  the  rule  was  changed.  Obviously,  the 
Commission  is  disregarding  both  experience  and  the  law  if  it 
permits  such  willingness  to  be  the  controlling  factor  in  its  de- 
termination. Formerly  the  law  was  that  the  judgment  of  the 
promoters  was  to  determine  the  result.  The  legislature  and 
the  people  have  come  to  distrust  that  judgment  and  have  sub- 
stituted In  place  thereof  the  judgment  of  the  Commission. 
The  Commission  must  exercise  its  judgment  if  it  is  not  to 
violate  its  duty. 

"Popular  desire  in  the  locality  or  localities  through  which 
it  is  proposed  to  construct  the  road  has  not  been  made  the  de- 
termining test.  It  would  have  been  easy  enough  to  have  made 
it  so,  had  that  been  deemed  wise  or  prudent.  An  experiment 
has  been  made  in  that  direction,  the  memory  of  which  yet 
lingers  in  many  counties  of  the  State.  By  chapter  907  of  the 
laws  of  1869  municipalities  were  authorized  to  issue  their 
bonds  for  stock  of  a  proposed  railroad.  A  considerable  amount 
of  experience  of  a  very  costly  nature  was  accumulated  during 
the  next  five  years,  and  on  November  3,  1874,  the  people  voted 


314  CAPITALIZATION 

nearly  two  to  one  to  amend  the  Constitution  so  as  to  forever 
forbid  further  experiments  of  that  nature.  If  locaHties  are  not 
to  be  permitted  to  expend  their  own  money  in  new  railroad 
enterprises,  their  interest  in  the  investment  of  other  people's 
money  in  such  enterprises  may  be  deserving  of  high  respect 
but  can  scarcely  be  deemed  conclusive  or  controlling."  ^ 

§  159-     (2)  Basis  of  Right  for  Protection  Against  Competition 

Under  a  policy  of  regulation  it  is  quite  evident  that  cor- 
porations subject  thereto  have  at  least  the  semblance  of  a 
right  to  occupy  undisputed  the  territory  which  they  have  appro- 
priated by  an  overt  attempt  to  render  service  therein.  In  fact, 
it  is  more  than  a  semblance  of  right;  it  must  be  considered  as 
a  legal  right  and  enforcible  by  injunction,  provided  the  corpo- 
ration seeking  to  avail  itself  of  that  right  has  affirmatively 
established  a  claim  and  continues  to  keep  it  by  readiness  and 
ability  to  serve  the  community.  Thus,  the  Public  Service  Com- 
mission (Second  District)  of  New  York  denied  a  certificate  of 
public  convenience  and  necessity  to  the  Buffalo,  Rochester  and 
Eastern  R.  R.  Co.^  upon  the  principal  ground  that  it  would 
compete  with  an  established  road  whose  "existing  railroad 
facilities  between  the  terminals  named  and  over  the  proposed 
road  are  adequate  for  existing  business,"  and  adequate  for  very 
large  increases  in  future  traffic,  so  that  there  was  "no  reason 
to  suppose  the  existing  railroad  will  not  be  able  to  increase 
the  carrying  capacity  as  rapidly  as  the  rail  and  lake  carriers 
west  of  Buffalo  increase  their  ability  to  offer  them  traffic." 

A  company  cannot  challenge  the  right  of  another  corpora- 
tion to  enter  a  certain  territory  unless  it  is  actually  in  that  terri- 
tory. Of  course,  there  may  be  a  contest  between  two  com- 
panies as  to  which  shall  be  permitted  to  occupy  the  territory, 


3  Matter  of  Buffalo,  Rochester  &  Eastern  R.  R.  Co.,  i  P.  S.  C.  Rep.  (2nd  D  N  Y  i 
5'3'2  (S47)-  •.      •      ./ 

*  This  company  proposed  to  build  a  road  from  Buffalo  to  the  seaboard  at  a  total 
cost  of  $100,000,000.  Its  application  was  twice  heard  by  the  Public  Service  Commission 
and  twice  denied.     See  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  532  and  2  P.  S.  C.  Rep.  (2nd  D.. 


N.  Y.)  ss 


COLLATERAL  ASPECTS  OF  REGULATION 


315 


but  in  such  a  contest  the  protection  of  invested  capital  is  not 
involved.  It  may  be,  however,  that  one  of  the  contestants 
occupies  contiguous  or  nearby  territory  so  that  the  contested 
territory  may  be  said  to  be  within  the  sphere  of  the  probable 
extension  of  its  service.  Such  a  case  was  presented  to  the 
Public  Service  Commission,  Second  District,  in  the  appHcation 
of  the  Islip  Electric  Light  Company  ^  to  exercise  a  franchise 
in  the  villages  of  Islip  and  East  Islip,  New  York.  The  appli- 
cation was  opposed  by  the  Suffolk  Gas  and  Electric  Light  Com- 
pany upon  the  grounds  that  "it  is  already  in  the  occupancy  of 
the  territory  sought  to  be  served  by  the  petitioner  and  that  it  is 
at  the  present  time  serving  satisfactorily  the  people  of  Islip  and 
East  Islip  with  electric  light  and  power." 

The  question  to  be  decided  was  how  far  the  contestant 
could  be  said  to  be  occupying  the  disputed  territory. 

"The  petitioner  has  failed  to  show  that  the  respondent  is 
not  at  the  present  time  competent  and  able  to  give  good  and 
sufficient  service  to  the  territory  in  question.  Apparently  it 
can  render  such  service  if  called  upon  and  given  an  opportunity 
by  the  public  of  the  villages  so  to  do. 

"The  question,  therefore,  is  reduced  solely  to  one  of  occu- 
pancy of  territory It  must  be  found  that  at  the  com- 
mencement of  this  proceeding  the  respondent  company  was  al- 
ready occupying  and  serving  the  western  fringe  only  of  the 
territory  under  consideration  here,  whatever  may  have  been 
its  willingness  to  extend  its  service  into  other  parts  of  it. 

"Under  these  circumstances  a  new  company,  composed  of 
residents  of  the  village  and  financed  by  local  capital,  asks  for 
permission  to  begin  operation  in  what  must  be  deemed  new 
and  virgin  territory  so  far  as  electric  service  is  concerned. 
Its  incorporators  proved  on  the  hearing  a  decidedly  hostile 
frame  of  mind  on  the  part  of  the  community  of  Islip  and  East 
Islip  towards  the  respondent  company,  caused  principally  by 
the  failure  of  that  company  in  the  past  to  give  good  gas  service, 

"Islip  Electric  Light  Co.,  a  P.  S.  C.  Rep.   (2nd  D.,  N.  Y.)  4115   (422-424). 


3i6  CAPITALIZATION 

and  the  people  of  those  villages  evinced  an  unwillingness  to 
take  electricity  from  respondent  on  any  terms. 

"Under  such  circumstances  the  Commission  feels  itself 
constrained  to  grant  the  application.  There  can  be  no  question 
of  the  duplication  of  distributing  plants,  erection  of  two  sets 
of  poles  and  the  stringing  of  unnecessary  wires,  because  the 
respondent  company  has  at  the  present  time  practically  no 
plant  in  operation  in  the  territory;  nor  would  the  respondent 
have  been  justified  from  an  economic  standpoint  in  construct- 
ing one  until  there  had  been  sufficient  call  for  electric  current 
from  the  public  to  be  served.  Such  a  call,  according  to  the 
testimony,  the  public  has  no  intention  of  giving  to  re- 
spondent, although  the  territory  may  be  said  to  be  within  the 
logical  sphere  of  its  activities.  There  is  no  question  involved 
of  vested  interests  which  would  be  injured  by  undue  competi- 
tion. The  petitioner  is  the  first  in  the  field  and  entitled  to  the 
preference.  While  the  Commission  may  feel  that  as  a  busi- 
ness proposition  it  would  be  more  economical  for  the  people 
of  Islip  and  East  Islip  to  take  their  electric  light  and  power, 
provided  they  can  make  reasonable  terms  therefor,  from  the 
Suffolk  Gas  and  Electric  Light  Company,  it  does  not  consider 
that  it  is  its  function  to  do  more  in  a  case  of  this  kind  than  to 
refer  to  such  a  course." 

It  is  of  interest  to  know  that  within  a  very  short  time  this 
new  corporation  was  merged  into  another  corporation  under 
the  control  of  the  Suffolk  Company. 

§  1 60.     (3)  Loss  of  Right  for  Protection  Against  Competition 

An  operating  corporation  which  is  both  able  and  willing  to 
furnish  the  quantity  of  service  demanded  may  have  lost  its 
right  to  claim  protection  against  competition  by  continued  in- 
difference to  the  legitimate  demands  of  the  community  as  to 
quality  of  service  or  the  conditions  under  which  that  service 
will  be  available. 

"Established  companies  should  understand  that  the  security 


COLLATERAL  ASPECTS  OF  REGULATION 


317 


to  their  investment  depends  upon  giving  all  the  service  to 
which  the  public  is  reasonably  entitled,  and  such  service  as 
the  state  of  the  art  fairly  requires.  When  this  has  been  done 
and  continues  to  be  done,  they  may  confidently  rely  upon  im- 
munity from  unwarranted  or  piratical  attacks."  ^  But,  "if  an 
existing  concern  is  serving  the  public  in  an  unsatisfactory 
manner,  it  is  entitled  to  little  consideration  when  it  seeks  to 
exclude  competition."  ^ 

The  defaults  of  an  operating  company  upon  which  the 
right  of  another -to  enter  its  territory  are  to  be  predicated,  must 
be  of  a  serious  and  substantial  nature. 

"The  policy  of  this  Commission,  in  cases  where  one  light- 
ing company  seeks  to  enter  a  field  already  occupied  by  another, 
requires  that  the  applicant  shall  show  that  the  company  already 
serving  the  community  is  not  doing  so  adequately  and  effi- 
ciently and  that  its  failures  are  such  that  they  cannot  well  be 
corrected  by  the  exercise  of  the  regulative  powers  of  the  Com- 
mission. Good  service  may  now  be  obtained  at  reasonable 
prices  in  less  expensive  ways  than  by  unnecessary  duplication 
of  plants,  and  the  public  interest  does  not  demand  that  capital 
invested  in  good  faith  in  the  public  service  should  be  de- 
stroyed or  impaired  without  good  reasons  to  be  shown  affirma- 
tively." « 

§  161.  (4)  Requisites  for  Authorization  of  New  Enterprises 
Communities  will  especially  welcome  a  new  corporation 
which  promises  to  furnish  service  at  a  lower  rate  than  that 
of  the  present  company.  Communities  have  always  invited 
such  projects,  and  have  always  paid  dearly,  but  they  will 
nevertheless,  continue  to  grow  enthusiastic  over  the  possibility 
of  competition.  Too  often  they  need  to  be  saved  from  them- 
selves, with  no  thanks  to  the  saviour. 


«  Citizens  Electric  Service  Company,  i  P.  S.  C.  Rep.   (2nd  D.,  N.  Y.)  336  (345). 
''  Heading  in  Katonah  Lighting  Company,  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  46,  quoted 
with  approval  in  Citizens  case,  cited  above. 

*  Niagara  Falls  Lighting  Co.,  2  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  116  (126). 


3i8 


CAPITALIZATION 


"The  mere  offer  by  an  applicant  seeking  to  enter  a  territory 
already  served  by  another  company  to  reduce  rates  is  in- 
sufficient, standing  wholly  alone,  to  justify  an  authorization 
to  make  such  entrance  without  further  inquiry  as  to  the 
adequacy  of  the  rate  to  afford  continuous  high  class  service, 
and  as  to  the  ability  of  the  company  already  serving  the  terri- 
tory to  reduce  its  rates  to  meet  those  proposed.  If  the  existing 
rate  is  unreasonable,  the  Commission  has  the  power  to  reduce 
it.  If  the  proposed  rate  is  not  adequate  to  maintain  the  service 
at  the  proper  standard  and  yield  some  return  upon  the  invest- 
ment, it  should  not  be  considered.  If  the  applicant  can  afford 
to  give  the  lower  rate  and  maintain  the  standard  of  service, 
and  the  company  serving  the  public  cannot  do  so,  then  the  right 
of  the  public  to  the  lower  rate  is  paramount  and  other  con- 
siderations must  give  way.  The  progress  of  the  world  is  de- 
pendent upon  this  principle."  ^ 

The  corporation  seeking  to  enter  a  certain  community 
cannot  expect  the  grant  of  authority  as  a  matter  of  course,  if 
its  application  has  not  been  opposed  or  if  contestant  has  been 
proved  unworthy  of  protection.  It  should  produce  affirma- 
tive proof  that  it  is  financially  able  to  begin  and  continue  suc- 
cessfully the  enterprise  which  it  proposes  to  engage  in.  The 
question  is  equally  serious  whether  the  company  is  seeking  to 
enter  a  field  already  occupied  or  one  in  which  it  meets  no  com- 
petition. If  it  is  permitted  to  enter  a  field  already  occupied 
when  it  is  not  financially  equipped  for  the  full  measure  of  the 
undertaking  it  may  mean  not  only  the  loss  of  such  sums  as 
investors  may  put  into  that  enterprise,  but  also  complete  or 
substantial  loss  to  the  other  company  because  of  the  ruinous 
competition  to  which  it  will  be  subjected.  On  the  other  hand, 
should  such  a  corporation  enter  a  field  representing  virgin  ter- 
ritory, among  the  evils  which  may  follow  are  the  loss  to  in- 
vestors, the  discouragement  to  other  investments  of  capital  in 


*  Matter  of  Oswego  River  Power  Transmission  Co.,  3  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.) 
268  (273-274). 


COLLATERAL  ASPECTS  OF  REGULATION      310 

a  similar  enterprise,  and  the  extended  economic  effects  pro- 
duced by  the  failure  of  the  enterprise — effects  which  are  not 
limited  to  the  boundaries  of  local  communities  and  are  not  con- 
fined to  brief  periods  of  time.  Among  the  reasons  set  forth 
by  the  Public  Service  Commission  for  its  denial  of  authority 
to  the  Buffalo,  Rochester  and  Eastern  Railroad  Company  was 
the  failure  of  the  applicant  to  show  sufficient  financial  ability, 
resources,  and  connections,  to  justify  the  belief  that  it  could 
construct  a  road  costing  $100,000,000.  The  proof  which  the 
Commission  had  desired  of  the  corporation  in  this  matter  was 
as  follows: 

"The  burden  of  proof  in  this  case  is  upon  the  applicant  to 
satisfy  the  Commission  that  the  gentlemen  engaged  in  this 
enterprise  are  engaged  in  it  in  good  faith,  that  they  are  per- 
sons of  experience  and  persons  of  responsibility  and  not  mere 
adventurers.  It  also  devolves  upon  the  applicant  to  show  that 
possessing  all  these  qualifications,  financial  and  personal,  there 
is  some  reasonable  probability  or  prospect  that  the  corpora- 
tion itself,  being  a  corporation  with  an  authorized  capital 
stock  of  $3,500,000,  with  of  course  only  one-tenth  of  it  sub- 
scribed at  the  present  time,  is  capable  of  financing  this  opera- 
tion of  this  proposed  road.  Now,  unless  the  applicant  satisfies 
the  Commission  of  the  latter  fact,  as  well  as  the  other,  it  will 
necessarily  have  to  fail  in  this  application."  ^° 

§  162.     Regulation  of  Rates 

The  regulation  of  rates  is  considered  to  be  the  most  im- 
portant function  of  public  service  commissions;  it  is  supposed 
to  affect  the  greatest  number  of  persons.  The  necessity  for 
it  arises  directly  from  the  monopolistic  nature  of  these  cor- 
porations. Protection  of  the  patrons  of  a  utility  demands  that 
the  charge  made  against  them  for  the  service  rendered  shall 
be  no  greater  than  is  warranted  by  an  investment  necessary  to 


1°  Matter  of   Buffalo,   Rochester  &   Eastern   R.   R.   Co.,   i    P.   S.   C.   Rep.    (ind  D., 
N.  Y.)  532  (607-8). 


320 


CAPITALIZATION 


furnish  that  class  of  service ;  that  it  shall  be  no  less  is  the  de- 
mand of  the  utility  which  asks  protection  from  ruinous  com- 
petition, or  from  the  necessity  of  dividing  with  another  the 
available  business  in  its  territory.  How  to  arrive  at  that  charge 
has  been  a  problem,  the  attempted  solution  of  which  more 
than  anything  else  has  influenced  the  development  of  public 
regulation. 

Rates  and  Capitalization.  Is  there  a  necessary  relationship 
between  rates  and  capitalization?  Where  both  are  subject  to 
regulation  is  there  any  requirement  of  law  or  public  policy 
that  the  one  be  controlling  as  to  the  other?  A  great  deal  of 
protest  was  raised  against  the  statement  in  the  report  of  the 
Railroad  Securities  Commission  that:  "If  railroad  securities 
were  to  be  issued  only  after  express  authorization  of  each  par- 
ticular issue  by  the  Interstate  Commerce  Commission  or  other 
governmental  agency,  it  is  difficult  to  see  how  the  government 
can  thereafter  correct  the  moral  if  not  the  legal  obligation  to 
recognize  these  securities  in  the  regulation  of  railroad  rates." 
It  has  been  urged  that  there  exists  neither  moral  nor  legal 
obligation;  that  rates  are  not  based  upon  the  amount  of  stocks 
and  bonds  outstanding  but  upon  the  investment,  and,  if  there 
is  such  a  discrepancy  between  the  actual  investment  and  .the 
capitalization  that  a  fair  rate  based  on  the  former  will  not 
support  the  value  of  the  latter,  the  investor  must  suffer  the 
loss.  There  needs  to  be  a  clear  distinction  between  two  situa- 
tions: the  one  where  stocks  and  bonds  have  been  issued  and 
their  proceeds  used  under  the  authorization  of  the  same  com- 
mission which  seeks  to  regulate  the  rates,  and  the  other  where 
the  status  of  the  corporation's  investment  and  capitalization 
had  become  fixed  before  regulation  was  undertaken.  In  the 
latter  situation  there  may  be  basis  for  the  assertion  that  the 
amount  of  outstanding  stocks  and  bonds  should  not  be  per- 
mitted to  influence  the  determination  of  rates,  but  even  here 
there  may  be  considerations  of  public  policy,  pointed  out  here- 
inafter, which  will  require  that  the  effect  of  proposed  rates 


COLLATERAL  ASPECTS  OF  REGULATION     321 

upon  the  present  capitalization  be  carefully  considered.  In 
the  first  situation,  however,  there  is  a  degree  of  interdepen- 
dence which  may  make  the  one  controlling  as  to  the  other. 

If  the  commission  authorizes  an  issue  of  securities  and 
passes  upon  the  incidents  of  their  sale  and  disposition  of  the 
proceeds,  it  must  necessarily  have  made  certain  assumptions 
somewhat  as  follows:  the  cost  of  constructing  plant  and  getting 
the  project  under  way  will  be  so  much;  to  meet  that  cost  so 
many  shares  of  stock  and  so  many  bonds  will  be  issued;  in 
estimating  the  number  of  shares  and  bonds,  it  will  necessarily 
have  considered  the  probable  price  at  which  they  would  be  sold, 
and  since  there  is  no  power  which  can  force  investors  to  pur- 
chase them  at  any  price,  the  commission  must  have  put  itself 
in  the  place  of  the  supposed  investor  and  concluded  that  at  a 
certain  price  the  purchase  of  these  securities  will  be  a  good  in- 
vestment in  view  of  the  probable  earnings — to  wit,  the  esti- 
mated available  business  times  the  proposed  rate.  Now  as  to 
the  rate,  two  things  are  possible:  either  it  was  based  on  the 
prevailing  standard  for  similar  service,  or  it  was  computed  on 
the  basis  of  the  cost  of  service  to  the  company  plus  a  return 
upon  the  company's  investment.  In  any  event,  some  certain 
rate  was  a  necessary  consideration  in  the  commission's  assump- 
tions. Suppose  the  commission  is  then  called  upon  to  fix  the 
rate,  there  having  been  no  changes  in  the  estimates  of  available 
business  and  costs,  could  it  order  a  rate  different  from  that 
contemplated  in  connection  with  the  computations  regarding 
capitalization? 

The  Massachusetts  Commission  has  made  a  clear-cut  state- 
ment of  an  unqualified  responsibility.  In  a  street  railway 
case  ^^  it  said: 

"The  statutes  under  which  these  stocks  and  bonds  were 
issued  ....  made  it  necessary  for  the  Board  of  Railroad 
Commissioners  to  find  that  the  issues  were  'reasonably  requi- 
site' or  'reasonably  necessary'  for  lawful  corporate  purposes, 

^  In  re  Blue  Hill  Street  Railway  Co..  P.  U.  R.  igiS-E,  371  (381). 


322  CAPITALIZATION 

before  it  could  give  its  approval.  In  like  manner,  the  statutes 
under  which  the  property  and  franchises  of  the  Milton  Street 
Railway  Company  were  purchased  ....  made  it  impossible 
for  the  purchase  to  take  effect  until  its  terms  had  been  ap- 
proved by  the  Board.  The  approval  of  these  issues  by  the 
Board,  coupled  with  its  approval  of  the  terms  of  the  Milton 
purchase,  must  therefore  be  regarded  as  conclusive  evidence, 
so  far  as  the  Commonwealth  and  this  Commission  are  con- 
cerned, that  the  stock  and  bonds  so  issued  represented  legiti- 
mate investment,  not  excessive  for  the  purpose,  and  as  strong 
presumptive  evidence  that  the  investment  was  'prudently'  made 
within  the  meaning  of  the  rule  ^^  laid  down  in  the  Middlesex 
and  Boston  rate  case. 

"It  does  not  follow  necessarily  that  the  company  is  fairly 
entitled  to  earnings  which  will  enable  it  to  pay  dividends  upon 
its  stocks,  or,  indeed,  interest  upon  its  bonds.  The  Common- 
wealth has  not  guaranteed  these  securities,  nor  undertaken  to 
protect  stockholders  or  creditors  against  the  consequences  of 
mismanagement.  If  the  company  has  waste  fully  or  im- 
prudently expended  corporate  funds  obtained  from  other 
sources,  or  has  in  any  other  way  been  improperly  managed,  and 
if  such  mismanagement  is  the  cause  of  a  failure  to  earn  divi- 
dends or  interest,  the  company  is  the  author  of  its  own  mis- 
fortunes, and  the  public  cannot  justly  be  taxed  through  the 
payment  of  higher  fares  to  relieve  its  embarrassment." 

Having  once  recognized  the  reasonableness  of  the  issue  of 
a  certain  amount  of  stock  and  bonds  as  necessary  for  the  pur- 
pose of  a  prudent  and  honest  investment,  the  Commission  pro- 
poses later  to  accept  that  amount  as  a  basis  for  rate-computa- 
tions. This  is,  obviously,  the  just  thing  to  do.  The  Commis- 
sion is  not  proposing,  however,  to  accept  the  amount  of  stock 
and  bonds  as  a  basic  fact  in  and  of  itself  but  rather  as  the 


We  rule  that  under  Massachusetts  law  capital  honestly  and  prudently  invested 
must,  under  normal  conditions,  be  taken  as  the  controlling  factor  in  fixing  the  basis 
for  computing  rates;  ....  that  reproduction  cost,  either  with  or  without  depreciation, 
while  It  may  be  considered,  is  not,  under  our  law,  to  be  taken  as  the  determining  basis 
for  reckoning  rates." 


COLLATERAL  ASPECTS  OF  REGULATION 


323 


representative  of  a  fact,  viz.,  the  investment  honestly  and 
prudently  made.  It  may  depart  from  that  amount  at  any  time 
if  the  fact  is  found  to  be  otherwise,  but  the  Commission 
acknowledges  that  as  long  as  the  circumstances  surrounding 
the  investment  remain  as  they  were  presented  to  it  when  the 
capitalization  was  authorized,  it  will  be  estopped  from  finding 
a  different  measure  of  the  investment  from  the  amount  of 
stock  and  bonds  which  it  had  itself  authorized. 

The  existing  capitalization  will  always  be  a  material  con- 
sideration in  a  rate  case,  either  because  of  principles  of  estoppel 
operating  upon  the  commission  as  above  suggested,  or  because 
of  the  possible  effect  upon  corporate  credit,  future  financing, 
etc.,  but  it  will  be  only  a  consideration,  and  will  not  exercise 
a  direct  and  controlling  influence  on  rates.  The  remoteness 
of  the  relationship  between  capitalization  and  rates  has  been 
already  suggested  in  §  138. 

§  163.     Regulation  of  Operations 

The  regulation  of  operations  is  the  counterpart  of  the 
regulation  of  rates.  Any  change  in  operating  conditions  must 
be  reflected  in  the  cost  of  the  service,  and  that  cost  must  be 
absorbed  in  the  rate.  To  increase  the  cost  is  tantamount  to 
decreasing  the  rate  so  far  as  the  effect  upon  the  company's 
earnings,  and  through  the  net  earnings  upon  the  value  of  its 
investment,  is  involved;  conversely,  to  decrease  the  cost  is  to 
increase  the  rate. 

Public  service  commissions  have  the  power  to  prescribe 
operating  standards,  schedules,  and  practices.  They  may  order 
structural  changes  or  repairs  for  the  betterment  or  mainte- 
nance of  service.  In  the  exercise  of  these  powers  they  will  be 
asked  to  consider  costs,  and  indirectly  they  will  control  ex- 
penses. It  is  of  vital  distinction,  however,  that  the  quality  or 
kind  of  service  will  be  thus  regulated  and  not  the  expense  to 
the  company ;  the  probable  effect  upon  costs  will  be  considered, 
but  the  actual  effect  is  not  regulated  and  will  depend  upon  the 


324  CAPITALIZATION 

arrangements  which  the  corporation  may  succeed  in  making  to 
comply  with  the  order. 

There  have  been  no  attempts  to  regulate  operating  costs 
directly.  The  practically  insurmountable  difficulties  which 
stand  in  the  way  are  obvious.  Manifestly,  it  would  be  either 
betrayal  of  the  public  interest  on  the  one  hand,  or  absolute 
foolishness  on  the  other,  to  predetermine- the  amounts  to  be 
paid  for  wages  and  materials.  If  the  prices  so  fixed  are  in- 
sufficient to  induce  others  to  sell  labor  or  materials,  the  opera- 
tions of  the  regulated  corporation  will  fail  and  the  public  be 
deprived  of  necessary  service.  Then,  again,  if  the  price  be 
greater  than  that  at  which  the  labor  and  commodities  could 
have  been  procured,  the  public  must  pay  a  greater  rate  for 
service  than  it  should.  On  the  other  hand,  should  the  price  be 
so  fortunately  fixed  as  to  represent  just  the  amount  at  which 
labor  and  commodities  could  be  procured,  it  will  be  precisely 
the  same  price  as  the  corporation  would  have  paid  wholly  in- 
dependent of  regulation. 

§  164.  Requirements  of  Public  Policy — (i)  Safeguarding  In- 
vestments 

The  exercise  of  the  regulative  power  of  a  commission  over 
the  capitalization  of  the  corporations  within  its  jurisdiction  is 
subject  to  a  number  of  considerations  not  specified  in  the  law 
but  imposed  by  general  public  policy.  These  are  given  in  this 
and  the  following  sections. 

Protection  of  an  existing  utility  against  unwarranted  com- 
petition is  the  protection  of  the  investor  who  has  committed 
his  capital  to  that  enterprise.  The  commitment  of  capital  has 
vested  in  him  property  rights  which  have  at  all  times  received 
the  substantial  protection  of  the  common,  constitutional,  and 
statutory  laws,  and  of  the  courts.  This  protection  has  been 
exercised  mainly  against  forces  operating  upon  the  corporation 
itself  and  upon  the  corporate  enterprise  from  the  outside,  e.g., 
in  the  making  of  confiscatory  rates. 


COLLATERAL  ASPECTS  OF  REGULATION      -,2S 

The  individual  investor,  however,  has  also  sought  and  has 
received  a  great  measure  of  protection  against  his  associates 
in  the  enterprise.  For  instance,  he  has  been  protected  against 
the  unfair  use  of  power  by  those  holding  the  controlling  inter- 
est, or  against  the  unconscionable  conduct  of  those  administer- 
ing the  corporate  affairs.  This  protection  has  been  accorded 
him  either  through  the  principles  of  the  common  law  or  by 
statutes.  Public  service  commission  laws,  so  called,  have  not 
produced  very  much  that  is  new  along  these  lines  except  so 
far  as  the  provisions  for  publicity  may  inure  to  the  better  pro- 
tection of  some  investors,  and  also  in  the  measure  that  the 
regulation  of  capitalization,  of  accounts,  and  of  operations  may 
indirectly  strengthen  the  position  of  the  invested  capital.  All 
these  results  undoubtedly  have  been  accomplished  by  these 
laws. 

So  much  for  the  man  who  has  already  invested  his  capital. 
It  has  been  a  very  interesting  question  whether  under  the  sys- 
tem of  regulating  public  service  corporations  in  the  occupa- 
tion of  territory,  the  issue  of  stocks  and  bonds,  etc.,  there  has 
not  been  evolved  a  new  public  responsibility  to  be  administered 
by  the  regulating  commissions,  to  wit,  that  of  protecting  people 
from  making  unwise  investments.  Does  an  authorization  to 
issue  securities  carry  with  it  the  guaranty  of  the  state,  and,  if 
so,  to  what  extent?  Does  it  not  at  least  carry  the  assurance 
that  they  have  been  scrutinized  by  prudent  men  and  found  to 
possess  investment  value  commensurate  with  the  price  at  which 
they  are  offered?  Does  it  not  also  carry  the  assurance  that  in 
the  administration  of  the  law  and  the  exercise  of  the  authority 
and  power  of  the  state,  adequate  provision  has  been  made 
for  the  proper  use  of  their  proceeds  and  a  sufficient  return 
thereupon  ? 

That  the  state  does  not  guarantee  securities  issued  pursuant 
to  the  authority  of  its  regulating  commission  is  well  under- 
stood, while  some  states  have  gone  to  the  extent  of  expressly 
disclaiming  the  responsibilities  of  a  guarantor;  for  instance, 


326 


CAPITALIZATION 


"No  provision  of  this  act,  and  no  deed  or  act  done  or  per- 
formed under  or  in  connection  therewith,  shall  be  held  or  con- 
strued to  obligate  the  State  of  California  to  pay  or  guarantee 
in  any  manner  whatsoever,  any  stock  or  stock  certificate  or 
bond,  note  or  other  evidence  of  indebtedness,  authorized, 
issued,  or  executed  under  the  provisions  of  this  Act." 

If  the  state  cannot  be  legally  held  as  the  guarantor  of 
securities  so  issued,  is  there  anything  in  the  laws  themselves  or 
in  the  nature  of  the  functions  performed  by  the  commissions 
to  carry  assurance  to  the  would-be  investor?  The  commission 
having  ordered  a  certain  rate,  the  ratepayer  is  entitled  to 
assume  that  the  rate  is  a  reasonable  one  and  may  rely  upon  the 
supposition  that  the  commission  has  fully  investigated  the 
facts.  Does  the  investor  occupy  any  relation  at  all  analogous 
to  that  of  the  ratepayer  to  the  extent  that  he  may  rely  upon  the 
supposition  that  the  commission  has  fully  acquainted  itself 
with  all  the  facts  connected  with  the  issue  of  the  securities 
which  it  has  authorized,  so  that  it  may  be  assumed  that  the 
securities  constitute  a  reasonable  investment?  Commissions 
have,  as  a  rule,  taken  the  stand,  expressed  over  and  over  again, 
that  they  do  not  vouch  for  the  investment  value  of  the  securi- 
ties which  they  authorize.  Yet  there  is  no  doubt  that  the  public 
has  placed  a  large  measure  of  confidence  in  these  authoriza- 
tions, and  the  conclusion  that  it  is  entitled  to  do  so  is  un- 
escapable. 

One  needs  only  to  review  the  record  of  the  avowed  pur- 
poses to  be  accomplished  by  the  enactment  of  these  laws,  and 
to  analyze  the  powers  given  to  these  commissions  and  the 
specific  duties  imposed  upon  them  in  order  to  ascertain  the 
reason  for  the  public  confidence  which  was  so  readily  reposed 
in  the  authorizations  of  the  commissions.  Since  the  laws  almost 
uniformly  prescribe  the  purposes  for  which,  and  the  conditions 
under  which,  securities  may  be  authorized,  it  follows  that  the 
authorization  carries  with  it  the  public  proclamation  that  the 
securities  are  for  a  proper  and  lawful  purpose,  issued  with  due 


COLLATERAL  ASPECTS  OF  REGULATION     327 

compliance  to  the  letter  and  spirit  of  laws  which  were  enacted 
to  remedy  abuses  and  to  enforce  correct  principles  of  capitali- 
zation. Moreover,  if  the  authorization  itself  determines  the 
price  of  issue,  it  is  reasonable  to  infer  that,  with  full  informa- 
tion and  mature  judgment,  the  securities  were  thought  to  be 
worth  that  price;  if  such  an  inference  were  to  be  denied,  regu- 
lation would  become  a  farce ;  it  would  mean  that  the  commis- 
sions themselves  lend  their  authority  to  the  perpetration  of 
fraud  in  seeking  to  bring  about  the  sale  of  securities  at  prices 
not  warranted  by  their  investment  value.  Such  broad  powers 
of  inquiry  are  given  to  the  commissions,  and  they  have  access 
to  such  an  amount  'of  data  unavailable  to  the  public  at  large, 
that  they  become  charged  with  a  well-defined  responsibility. 
The  public  assumes  that  this  is  duly  carried  out  and  acts  ac- 
cordingly. Quoting  the  Public  Service  Commission,  Second 
District,  New  York: 

"We  think  that  to  a  reasonable  extent  the  interests  of  the 
investing  public  should  be  considered  by  us  in  passing  upon 
these  applications.  The  Commission  should  satisfy  itself  that, 
in  a  general  way,  the  venture  will  be  likely  to  prove  com- 
mercially feasible,  but  it  should  not  undertake  to  reach  and 
announce  a  definite  conclusion  that  the  new  construction  or 
improvement  actually  constitutes  a  safe  or  attractive  basis  for 
investment.  Commercial  enterprises  depend  for  their  success 
upon  so  many  conditions  which  cannot  be  foreseen  or  reckoned 
with  in  advance  that  the  duty  of  the  Commission  is  discharged 
as  to  applications  of  this  character  when  it  has  satisfied  itself 
that  the  contemplated  purpose  is  a  fair  business  proposition."^^ 

An  intimation  of  what  constitutes  the  "reasonable  extent" 
to  which  the  interests  of  the  investing  public  are  to  be  con- 
sidered is  contained  in  a  later  opinion  where  it  was  stated  that 
a  decision  of  the  Commission  holding  that  a  public  necessity 
for  the  construction  of  the  proposed  road  existed  would  be  "a 


"Matter  of  Hudson  River  Elec.   Pwr.  Corp.,  i  P.   S.  C.  Rep.   (2nd  D.,  N.  Y.)   51 
(67-68). 


328  CAPITALIZATION 

finding  upon  which  the  ptibHc  would  have  a  right  to  rely,  and 
upon  which  it  incontestably  would  rely,  that  the  road  would  in 
all  human  probability  afford  an  adequate  return  upon  the 
money  invested  in  its  construction.  The  decision  of  the  Com- 
mission would  unquestionably  be  paraded  before  would-be  in- 
vestors to  satisfy  them  that  they  could  safely  put  out  their 
money  in  this  scheme  with  a  just  expectation  of  an  adequate 
return  thereon.  The  Commission  cannot  be  expected  to  make, 
a  finding  which  would  produce  such  a  result,  unless  it  were 
thoroughly  satisfied  of  the  correctness  of  such  finding."  " 

"Beyond  any  question,  the  determination  of  the  question 
of  the  necessity  of  the  proposed  road  must  lie  largely  in  the 
solution  of  the  question  whether  the  earnings  from  its  opera- 
tion would  be  sufficient  to  pay  any  adequate  and  proper  return 
upon  the  money  invested  in  its  construction.  The  law  requiring 
the  granting  of  a  certificate  of  public  convenience  and  a  neces- 
sity was  enacted  for  the  purpose  of  preventing  the  construc- 
tion of  bankrupt  roads  and  for  the  prevention  of  the  evils 
which  would  follow  .from  such  construction.  If  it  is  clearly 
apparent  that  a  road  will  be  bankrupt  from  the  outset,  the 
granting  of  a  certificate  of  public  convenience  and  a  necessity 
would  be  a  direct  violation  of  the  spirit  and  purpose  of  the 
statute  which  should  not  be  tolerated."  ^^ 

In  still  another  case,  this  Commission  was  not  satisfied  as 
to  the  adequacy  of  earnings  to  support  the  bond  issue  out  of 
which  it  was  proposed  to  build  a  certain  extension.  Upon  its 
suggestion,  therefore,  the  corporation  agreed  to  reduce  the 
bond  issue  and  sell  shares  of  stock  instead.  "With  this  limita- 
tion of  bond  issue,"  said  the  Commission,  "it  is  believed  that 
the  extension  would  have  a  sufficient  prospect  of  success  to 
justify  the  Commission  in  consenting  to  the  construction."^^ 

The  aspect  of  commission  regulation  which  has  been  the 

"  Matter  of  Buffalo,  Rochester  &  Eastern  R.  R.  Co.,  3  P.  S.  C.  Rep.  (2nd  D. 
N.  Y.)  55  (125,). 

1'  Id.,  pages  93-94. 

^'Matter  of  Catskill  Traction  Co.,  3  P.  S.  C.  Rep.   (2nd  D.,  N.  Y.)   189,  205. 


COLLATERAL  ASPECTS  OF  REGULATION 


329 


most  emphasized  by  the  courts  has  been  that  of  protecting  the 
investor;  they  have  repeatedly  given  expression  to  the  con- 
cept of  guardianship.  The  New  York  Court  of  Appeals  has 
said:  "It  was  designed  to  make  the  Commissioners  the 
guardians  of  the  public  by  enabling  them  to  prevent  the  issue 
of  stock  and  bonds  for  other  than  the  statutory  purposes."^^ 
The  Maryland  Court  of  Appeals  says:  "The  legislatures  of 
many  states  have  ....  through  the  media  of  public  service 
commissioners,  seen  fit  to  establish  a  quasi-guardianship  over 
prospective  investors."  ^^ 

The  following  quotation  from  a  dissenting  opinion  of  a 
former  member  of  the  New  York  Second  District  Commission 
in  the  Buffalo,  Rochester  and  Eastern  case,  contains  a  clear 
exposition  of  an  opposite  attitude  as  to  the  extent  of  the  Com- 
mission's responsibility: 

"Where  a  satisfactory  showing  has  been  made  upon  the 
question  of  public  necessity  and  convenience,  I  hold  that  the 
plan  of  the  railroad  being  in  itself  a  reasonable  one,  if  the 
public  be  in  no  wise  deceived  as  to  the  character  of  the  enter- 
prise or  the  securities  which  it  offers;  and  if,  after  due  con- 
sideration of  all  objections  raised  in  opposition  or  by  the  un- 
prejudiced judgment  of  the  Commission,  the  investors  still 
think  the  enterprise  a  good  one  upon  which  to  expend  their 
capital ;  then,  with  such  conditions  imposed  as  would  preserve 
all  due  rights  of  existing  roads  and  insure  the  proper  execution 
of  the  project,  the  certificate  should  be  granted. 

"I  do  not  hold  it  to  be  a  part  of  the  function  of  this  Com- 
mission to  prevent  people  from  making  bad  investments;  to 
attempt  that  will  open  the  door  to  all  forms  of  extravagant 
paternalism.  It  is  our  business,  as  I  take  it,  to  prevent  fraud 
and  dishonesty,  and  to  stop  overcapitalization  wherever  .pos- 
sible in  all  future  issues  of  public  service  corporation  securi- 
ties, as  such  overcapitalization  also  tends  to  result  in  fraud 


"People  ex  rel.  Delaware  &  Hudson  Co.  v.  Stevens,  197  N.  Y.  i. 
"Laird  V.  B.  &  O.  R.  R.  Co.,  ^  L.  R.  A.  (N.  S.)  1167. 


330 


CAPITALIZATION 


Upon  the  public.  Our  peculiar  function  is  to  make  the  relations 
of  public  service  corporations  toward  the  public  on  the  one 
hand,  and  the  state  on  the  other,  as  clear  and  honest  as  we 
can  make  them. 

"  .  .  .  .  When  we  take  the  application  of  a  railroad  com- 
pany which  proposes  a  perfectly  feasible  route — between  two 
of  the  largest  cities  in  the  state,  on  the  direct  line  of  through 
traffic — a  railroad  which  is  demanded,  apparently  without  a 
single  dissenting  voice,  by  the  people  of  fourteen  counties 
through  whi'ch  it  proposes  to  run ;  and  decline  to  allow  capi- 
talists to  invest  in  it  because  in  our  opinion  it  will  not  pay,  we 
are  setting  up  our  business  judgments  as  against  those  who  are 
most  interested,  because  they  are  the  ones  who  purpose  to  put 
their  money  into  the  road,  and  deciding  for  them  that  they 
must  not  be  allowed  to  make  a  certain  investment  because  in 
our  judgment  it  would  not  turn  out  profitably.  Such  a  de- 
cision, to  my  mind,  savors  of  a  paternalism  which  is  bound 
to  be  exasperating  in  the  present,  and  I  fear  is  a  rather  dire 
augury  for  the  future."  ^^ 

There  is,  of  course,  a  wider  application  of  the  principle  to 
the  application  of  which  exception  was  here  taken.  There  is 
the  general  public  good  which  must  be  considered,  to  the  extent 
that  preventable  loss  to  investors  should  be  avoided,  not  be- 
cause the  individual  investors  will  suffer,  but  because  the  com- 
munity at  large  will  suffer.  The  prevention  of  that  suffering 
is  not  a  paternalistic  act ;  it  is  a  legitimate  exercise  of  govern- 
mental function. 

§  165.     (2)  Conserving  Integrity  of  Credit 

The  public  is  entitled  to  such  regulation  as  will  maintain 
the  integrity  of  existing  money  markets,  uphold  credit,  and 
encourage  the  investment  of  capital.  This  requirement  of 
public  policy  is  superior  to  the  local  interest  of  the  patrons  of 
any  one  utility,  or  that  of  the  investors  therein.    The  applica- 

^'  Appended  to  decision  after  first  hearing  and  reported  in  i    P.   S.   C.   Rep.    (2nd 
D.,  N.  Y.)  628,  629.  ^  y  i-^  V 


COLLATERAL  ASPECTS  OF  REGULATION 


331 


tion  of  this  principle  is  invoked  most  often  in  rate  cases,  but 
it  has  force  in  relation  to  capitalization  problems  as  well. 

It  is  said  that  corporations  have  no  souls,  and  perhaps  for 
that  reason  they  do  not  feel  their  loneliness.  They  have  few 
friends  at  best,  and  a  public  service  corporation  has  usually 
the  least  number  while  having  the  greatest  number  of  enemies. 
Every  hearing  before  a  commission  is  therefore  frequently 
taken  advantage  of  by  many  classes  of  persons  to  bring  up 
charges  of  overcapitalization,  excessive  rates,  inadequate  ser- 
vice, incompetence,  and  indifference,  and  all  manner  of  corpor- 
ate wrong-doing.  Unfortunately  it  is  true  that  opposing  the 
corporation  is  too  often  made  synonymous  with  befriending 
the  public,  and,  vice  versa,  defending  the  cause  of  the  corpora- 
tion is  made  tantamount  to  betrayal  of  the  public.  This  at- 
titude has  encouraged  many  to  seek  popularity  and  personal 
power  by  always  demanding  additional  service  and  lower  rates 
from  the  corporation,  and  concurrently  increasing  taxes,  de- 
manding franchise  fees,  and  opposing  additional  capitalization. 
If  all  these  efforts  could  succeed,  the  public  service  enterprise 
would  come  to  a  Samsonian  end ;  it  would  eventually  succumb 
before  its  harassers,  at  the  same  time  destroying  their  welfare 
also.  The  results  would  be  loss  of  capital,  and  loss  to  the 
patrons  of  the  service,  but  worst  of  all  would  be  the  loss  of 
faith  and  credit  which  would  penalize  worthy  projects  because 
of  the  unwillingness  of  investors  to  place  capital  at  the  hazard 
of  attack  if  there  is  the  prospect  of  prejudice  being  the  victor. 

Public  service  commissions  will  often  be  asked  to  accede  to 
the  wishes  of  the  interested  public,  or  to  act  according  to  the 
behests  of  those  who  measure  public  interest  by  the  scope  of 
their  own  narrow  outlook.  It  will  be  easiest  and  most  popular 
for  a  commission  to  follow  this  course,  but  it  is  to  the  credit  of 
most  commissions  that  they  have  clearly  understood  the  nature 
of  their  task  and  held  true  to  the  performance  of  their  trust, 
thus  becoming  instruments  for  the  protection  of  the  public 
faith  and  credit.     These  commissions  are  not  the  agents  of 


332 


CAPITALIZATION 


the  patrons  of  the  pubHc  service  corporations  any  more  than 
tliey  are  of  the  investors  in  those  corporations;  they  are  trus- 
tees appointed  by  the  people  at  large,  and  in  their  custody  is 
placed  the  public  faith  and  credit  to  be  administered  without 
prejudice  or  self-interest. 

§  i66.     (3)  Promoting  the  Public  Interest 

In  a  number  of  ways  the  commission  will  find  it  necessary 
to  consider  the  interest  not  of  one  community  but  of  the  state 
and  people  in  general  while  passing  upon  applications  which 
include  proposals  to  issue  stocks  and  bonds.  For  instance,  al- 
though under  the  statutes  one  corporation  may  not  purchase 
the  plant  of  another  or  acquire  the  stock  of  another  without 
the  consent  of  the  commission,  there  are  few  express  instruc- 
tions of  the  law  that  the  commission  is  directed  to  follow,  and 
these  are  generally  limited  to  "anti-trust"  regulations  defining 
the  consolidations,  mergers,  and  other  combinations  which  are 
permissible.  In  the  main,  the  considerations  which  will  be 
controlling  as  to  the  decision  of  the  commission  will  be  those 
which  it  has  itself  set  forward  as  arising  out  of  public  policy. 

50  also  in  considering  apphcations  to  exercise  franchise  rights 
in  a  given  community;  the  community  itself  may  have  granted 
the  franchises  and  be  anxious  for  service  to  be  inaugurated, 
but  the  commission  must  stop  to  inquire  as  to  the  character  of 
service  proposed,  and  to  determine  whether  it  is  such  as  to  pro- 
mote the  public  interest. 

A  very  interesting  problem  was  presented  to  the  New  York 
Public  Service  Commission  in  an  application  for  authority  to 
construct  an  electric  generating  plant  upon  the  Sacandaga 
River  at  a  time  when  there  was  much  public  discussion  as  to 
committing  the  state  to  a  policy  of  water  power  development."" 
Tentative  surveys  were  also  under  way  with  a  view  to  possible 
construction  of  a  large  dam  by  the  state  upon  that  same  river 
at  a  point  very  near  to  that  intended  to  be  occupied  by  the 

^  Matter  of  Hudson  River  Electric  Power  Co.,  i   P.  S.  C.  Rep.   (2nd  D.,  N.  Y.) 

51  (72-74).  , 


COLLATERAL  ASPECTS  OF  REGULATION      333 

electrical  corporation.  It  was  for  the  Commission  to  decide 
whether  consent  should  be  given  to  the  private  development 
of  a  water  power  project  which  the  state  might  later  desire  to 
acquire.  There  is  no  indication  in  the  opinion  as  to  what 
decision  would  have  been  made  if  the  state  project  had  been  a 
fixed  one;  as  it  was,  the  application  was  granted  because  the 
Commission  had  not  been  advised  that  the  proposed  plan 
would  "interfere  with  the  public  health,  maintenance  of  the 
forest  preserve,  or  any  defined  project  of  the  state."  One  of 
the  Commissioners  dealt  with  these  particular  aspects  of  the 
application  very  fully  in  a  concurring  opinion.     He  said: 

"Obviously  this  Commission  is  not  called  upon  to  decide  as 
to  whether  such  policy  (the  proposed  policy  of  state  water 
power  development)  is  or  is  not  a  wise  one ;  nor  whether  being 
wise  or  unwise,  it  is  likely  or  not  to  be  carried  out  by  the  state 
either  now  or  in  the  future;  yet  it  is  the  duty  of  this  Commis- 
sion, If  it  be  possible,  to  so  act  that  if  the  state  should  decide 
to  follow  along  the  lines  indicated  by  the  Governor's  message 
and  the  Fuller  Bill,  no  action  of  this  Commission  shall  put 
the  state  in  a  less  advantageous  position  than  it  would  have 
been  in  if  this  Commission  had  not  acted. 

"In  other  words,  this  Commission  should  not  by  its  act 
enable  a  private  owner  to  gain  vested  rights  in  a  water  power 
which  will  force  the  state  later  on  to  pay  more  for  the  control 
of  that  water  power  than  a  sum  represented  by  the  amount 
actually  expended  by  such  private  owner  in  acquiring  and  im- 
proving the  property.  The  private  owner  should  not  be  per- 
mitted to  claim  over  and  above  the  actual  cost  of  his  invest- 
ment, the  unearned  value  which  the  action  of  the  state  itself 
has  created,  and  thus  make  the  state  pay  for  the  very  thing  it 
has  given 

"When  the  choice  comes  squarely  between  granting  or  re- 
jecting the  application  ....  there  is  this  further  considera- 
tion: The  conditions  seem  to  be  such  that  if  the  state  should 
ever  determine  to  develop  the  water  power  of  the  Sacandaga 


334 


CAPITALIZATION 


valley  it  could  do  so  with  such  manifest  advantage  to  the  Hud- 
son River  Electric  Power  Company  that  there  is  every  reason 
to  believe  that  company  would  have  every  incentive  to  further 
rather  than  hinder  such  development.  The  self-interest  of  the 
private  owners  may  thus  yield  to  the  state  what  the  state  might 
better  have  the  legal  right  to  exact." 


CHAPTER    XVI 

FIXED  AND  FLOATING  CAPITAL  AND  THE 
ACCOUNTING   THEREFOR 

§  167.     Fixed  and  Floating  Capital 

The  capital  of  a  public  service  corporation,  viz.,  "all  prop- 
erty devoted  to  the  rendering  of  the  services  or  the  production 
of  the  commodities  which  are  within  the  purposes  of  the  cor- 
poration," ^  is  divided  into  two  main  classes:  fixed  and  cir- 
culating (or  floating).  Circulating  capital  is  entirely  con- 
sumed in  the  rendition  of  a  particular  item  of  service;  fixed 
capital  remains  in  service  for  a  comparatively  long  period  and 
is  consumed  over  a  series  of  operations.  "Coal  on  hand  is  a 
current  or  floating  asset.  It  can  be  used  but  once  and  is  de- 
stroyed in  the  use The  machine  which  utilizes  the  energy 

furnished  by  the  combustion  of  the  coal  is  a  factor  in  the  pro- 
ductive process  but  is  not  classed  with  floating  assets  or  capital. 

It  can  be  used  again  and  again  during  a  term  of  years 

The  consumption  of  the  coal  is  visible  and  apparent;  the  con- 
sumption of  the  machine  is  not  visible,  extends  over  a  term  of 
years  and  through  a  long  series  of  production."  "  It  will 
readily  be  seen  that  the  distinction  between  the  two  kinds  of 
capital  is  mainly  one  of  degree  rather  than  of  kind  or  sub- 
stance. 

It  is  sometimes  difficult  to  distinguish  between  fixed  and 
floating  capital  without  some  established  rule,  and  an  arbitrary 
line  of  demarcation  is  usually  drawn  at  one  year,  thus  classi- 
fying as  fixed  all  capital  having  expectation  of  life  in  service 


"  Definition  from  Uniform  Systems  of  Accounts,  New  York  Public  Service  Com- 
missions. 

^  Matter  of  Binghamton  Light,  Heat  and  Power  Co.,  i  P.  S.  C.  Rep.  (2nd  D., 
N.  Y.)  171   (184). 

335 


336 


CAPITALIZATION 


of  more  than  one  year.  In  the  accounts  of  a  corporation  the 
disposition  of  cost  of  fixed  capital  is  very  different  from  that 
of  floating  capital.  The  usual  period  for  which  accounts  are 
assembled  and  studied  is  the  year,  hence  the  year  is  also  the 
standard  to  determine  the  character  of  capital.  That  which  is 
going  to  affect  the  accounts  for  a  period  longer  than  that  con- 
stituting the  fiscal  year  for  which  the  accounts  are  assembled 
is  fixed  capital;  that  which  will  affect  the  accounts  for  that 
period  only  is  floating  capital. 

Expenditures  upon  both  classes  of  capital  are  chargeable 
in  the  first  instance  to  accounts  the  balances  of  which  will  rep- 
resent assets  on  the  balance  sheet.  But  one  will  represent  a 
relatively  permanent  fact  and  be  classed  as  an  investment,  while 
the  other  will  appear  only  temporarily  in  a  Materials  and  Sup- 
plies account  pending  the  use  in  the  productive  process.  There 
it  will  be  wholly  consumed  and  its  cost  will  cease  to  be  an 
asset,  and  become  an  expense  of  operation  to  appear  in  the 
Income  account  and  not  on  the  balance  sheet. 

Obviously,  capital  which  will  continue  as  an  asset  after  the 
closing  of  the  Income  account  should  not  have  its  entire  cost 
charged  to  income,  for  then  it  will  be  recorded  as  an  expense  of 
operation  to  be  deducted  from  revenue,  with  the  result  on  the 
one  hand  that  the  gain  from  operation  will  appear  at  less  or 
the  loss  greater  than  it  should,  while  on  the  other  hand  the 
balance  sheet  will  fail  to  show  an  asset  on  hand  and  will  thus 
create  a  "secret  reserve,"  so  called.  And  yet,  this  very  prac- 
tice has  been  and  continues  to  be  considered  a  commendable 
one  as  denoting  a  conservative  policy  in  "building  up  the  capi- 
tal out  of  income."  Often  the  chief  excuse  for  the  practice 
is  the  pre-existence  of  another  error,  to  wit,  the  present  in- 
clusion in  the  balance  sheet  asset  accounts  of  amounts  which 
never  did  represent,  or  have  since  ceased  to  represent,  actual 
assets.  The  inflation  thus  introduced  into  balance  sheet  ac- 
counts is  then  sought  to  be  made  good  by  subsequent  acciuisi- 
tion  of  assets  through  income.     The  aim  is  all  right,  but  the 


FIXED    AND    FLOATING   CAPITAL 


337 


difficulty  is  that  neither  the  balance  sheet  accounts  nor  the  in- 
come accounts  will  represent  the  facts  they  purport  to  record, 
while  no  one  can  use  the  resulting  statements  in  any  way  to 
ascertain  how  much  the  inflation  was,  how  much  has  been  made 
good,  and  how  much  remains  to  be  made  good.  It  may  be  an 
eminently  worthy  act  to  apply  earnings  to  strengthening  cor- 
porate resources  rather  than  to  divide  them  as  dividends,  but 
there  are  more  appropriate  methods  of  recording  the  incidents 
of  such  an  act.^ 

§  i68.     Basis  of  Fixed  Capital  Accounts 

There  naturally  arises  at  this  point  the  question  as  to  the 
proper  basis  of  showing  fixed  capital  upon  the  balance  sheet. 
It  is  an  asset,  and  assets  are  supposed  to  represent  available 
values.  What  is  the  available  value  of  fixed  capital,  and  how 
can  it  be  ascertained  and  recorded? 

The  fixed  capital  account  of  an  operating  public  utility 
corporation  (distinguished  from  a  holding  company)  is  the 
most  important  record  which  it  can  have.  Upon  that  basic 
record  will  depend  the  value  of  all  future  records  of  opera- 
tions. Most  abuses  of  capitalization  have  been  made  possible 
by  manipulation  of  the  fixed  capital  account,  hence  the  im- 
perative demand  for  accuracy  and  detailed  accounting  in  this 
respect. 

Three  methods  of  showing  the  fixed  capital  upon  the 
balance  sheet  have  been  used.  The  first  is  based  on  the  original 
cost  of  the  fixed  capital  in  service ;  the  second,  on  present  value 
as  measured  by  the  probable  cost  to  reproduce  or  duplicate; 
the  third,  on  present  value  measured  by  the  earning  power  of 
the  capital  in  that  service  wherein  it  is  placed.  So  far  as  the 
initial  entries  for  a  new  corporation  are  concerned,  the  prac- 
tice would  not  vary  much  under  the  first  two  methods,  for  the 
cost  to  duplicate  must  necessarily  be  the  same  as  the  cost  to 
acquire.    Since  earning  power  has  not  been  developed,  it  would 

•See  Chapter  VII,  §69. 


338 


CAPITALIZATION 


seem  as  though  the  practice  under  the  third  method  would  pro- 
duce like  results  as  for  the  other  two.  A  singular  confusion  of 
the  theory  that  the  capitalization  should  show  earning  value, 
however,  together  with  the  belief  that  there  should  be  some  uni- 
formity in  the  relation  of  capital  to  the  par  value  of  stocks  and 
bonds  issued  against  it,  has  led  some  accountants  to  the  prac- 
tice of  entering  original  fixed  capital  or  subsequent  additions 
at  an  amount  equaling  the  par  value  of  the  stocks  and  bonds 
issued  for  the  purpose  and  altogether  irrespective  of  cost  or 
value.  The  more  obvious  purpose  is,  of  course,  that  of  escap- 
ing an  apparent  deficit  at  the  commencement  of  operations. 

Beyond  the  initial  entries  the  results  of  the  three  methods 
will  differ  widely.  Following  the  second  method,  the  original 
entries  would  be  changed  to  show  the  valuation  of  the  assets 
at  the  later  date,  the  account  being  written  up  or  down  by  the 
difference  between  the  present  and  the  last  valuation.  As  a 
rule,  however,  it  is  only  when  the  facts  are  so  obvious  as  to  be 
inescapable  of  notice  that  a  corporation  will  write  down  its 
capital  accounts — unless  it  has  a  large  apparent  surplus  which 
it  is  policy  to  diminish  otherwise  than  by  the  declaration  of 
dividends.  More  often  the  valuation  of  assets  is  sought  to  be 
made  by  friendly  interests,  and  upon  their  report  the  capital 
is  written  up  to  create  apparent  surplus  for  distribution  as 
dividends.  Upon  the  third  method  the  accounts  will  be  written 
up  or  down  (the  latter  being  very  seldom  done)  in  accordance 
with  a  valuation  of  the  property  reflecting  the  figures  of  earn- 
ings developed  in  operations. 

Neither  of  the  two  "value"  theories  (i.e.,  reproduction  cost 
or  capitalized  earnings)  will  be  found  upon  examination  to 
produce  the  results  desired  of  them.  Cost  of  reproduction  will 
represent  available  value  only  when  the  article  is  one  freely  re- 
produced, bought  and  sold.  Comparison  of  the  article  to  be 
valued  with  the  price  of  like  articles  on  the  market  will  give 
its  cost  of  reproduction  (allowing  for  present  conditions), 
which  will  be  its  available  (maximum)  value.    The  fixed  capi- 


FIXED   AND    FLOATING   CAPITAL  oog 

tal  of  public  utilities  lacks  these  characteristics  of  reproducible 
articles ;  it  is  impossible  to  find  two  plants  with  characteristics 
absolutely  identical — equal  in  quantity,  kind,  and  condition  of 
capital,  serving  territories  which  are  alike  in  point  of  demand 
for  service  and  willingness  to  pay  a  similar  rate.  Hence,  it  is 
impossible  to  get  the  value  of  one  plant  by  comparison  with 
another,  so  that  the  value  must  be  based  upon  a  series  of  facts 
relating  to  the  one  plant  under  consideration.  According  to 
the  nature  of  the  fact  examined,  the  "value"  thus  derived  will 
be  either  of  the  following:  (i)  It  may  be  an  abstract  and 
constructive  "value"  represented  by  the  aggregate  cost  of  the 
many  units  of  capital  which  have  gone  into  the  plant — which 
will  not  be  value  at  all  since  the  units  which  went  into  the 
plant  have  by  the  very  fact  of  use  lost  the  value  which  they 
theretofore  possessed  as  so  much  material  in  steel  rails,  piping, 
wire,  etc.,  and  collectively  have  assumed  a  new  value  which  is 
the  very  figure  sought  for.  (2)  Or  it  will  be  the  worth  to 
the  owners  of  the  plant  in  service  as  a  productive  machine; 
but  that  last  is  the  value  of  the  undertaking  as  a  whole,  not  at 
all  subject  to  allocation  among  classes  of  assets,  even  though  it 
is  bound  to  relate  most  of  all  to  the  fixed  capital,  which  is  the 
largest  asset  item.  This  second  result,  if  taken  upon  the  books, 
Vidll  represent  substantially  the  capitalization  of  earnings.  It 
follows  that  the  fixed  capital  cannot  be  shown  upon  the  balance 
sheet  under  either  of  the  "value"  methods. 

The  Test  of  Value.  The  measure  of  real  value  is  what  a 
person  will  give  for  the  article,  the  plant,  or  whatever  else  it 
may  be.  It  is  not  what  the  present  owner  paid  for  it ;  neither  is 
it  what  he  would  like  to  get  for  it.  On  the  other  hand,  it  is  not 
what  a  casual  buyer  will  offer,  but  rather  it  is  the  amount 
which  a  buyer  with  serious  purpose  and  complete  information 
as  to  the  condition  of  the  property,  the  volume,  kind,  and  cost 
of  the  business,  the  record  of  past  development,  and  reasonable 
prospects,  will  offer.  How  can  the  present  owner  anticipate 
the  amount  of  such  an  offer?    He  may  be  able  to  make  a  very 


240  CAPITALIZATION 

close  estimate,  but  in  his  calculations  he  will  take  into  con- 
sideration certain  ratios,  e.g.,  of  earnings  to  amount  invested, 
of  capital  representing  investment  of  earnings  to  original  capi- 
tal, of  cost  of  service  to  revenues,  etc.  All  these  facts  are  book 
records  which  would  be  modified  if  he  placed  on  the  books 
the  result  of  his  calculation  as  to  value,  and  which  in  turn 
would  necessitate  another  calculation,  and  so  on. 

The  Cost  Basis.  The  cost  of  the  plant  does  not  represent 
available  value.  It  is,  however,  a  fact  related  in  kind  and 
origin  (not  necessarily  comparable  in  amount,  however)  to 
other  facts  shown  upon  the  balance  sheet,  to  wit,  the  capital 
stock  and  bonds  which  were  issued  for  its  acquisition.  If  the 
corporation  had  to  account  to  its  bondholders  right  then  and 
there,  it  might  be  able  to  pay  a  fraction  only  of  the  par  of 
bonds,  and  nothing,  or  little,  on  the  par  of  stock.  Nevertheless, 
its  accounting  does  not  and  could  not  take  cognizance  of  such 
contingencies;  it  can  and  does  record  a  historical  fact — the 
obligation  of  a  promise  to  pay,  i.e.,  the  par  of  the  bonds,  and 
the  amount  received  from  stockholders.  It  would  be  illogical 
and  untruthful — for  a  half  truth  is  equal  to  an  untruth — to 
show  a  part  of  a  complete  transaction  on  one  basis  and  another 
part  on  another  basis.  Hence,  in  showing  the  stock  and  bonds 
in  the  manner  indicated,  the  corporation  must  show  on  a  like 
basis  the  capital  acquired,  except  as  parts  of  it  have  been  lost 
(e.g.,  abandoned  without  replacement  in  kind  or  value  of 
assets)  or  superseded  (e.g.,  replaced  in  kind  or  substituted  by 
another  asset;  for  example,  consumed  in  operation  and  its 
value  replaced  by  cash  or  some  other  current  asset).  That 
like  basis  is  cost — a  historical  fact  of  present  interest,  reflecting 
the  manner  in  which  the  corporation  has  discharged  its  re- 
sponsibility to  invest  in  the  business  the  proceeds  of  its  stock 
and  bond  issues.  Cost  in  terms  of  cash  is  the  basis  prescribed 
by  public  service  commissions  generally  and  by  the  Interstate 
Commerce  Commission  in  their  accounting  orders.  The  text 
of  the  general  instructions  for  fixed  capital  accounting  issued 


FIXED   AND    FLOATING   CAPITAL 


341 


by  the  New  York  Public  Service  Commissions  is  as  follows: 

"All  charges  made  to  capital  shall  be  the  actual  money  cost 
of  the  things  in  respect  of  which  they  are  made.  When  the 
consideration  actually  given  for  the  thing  in  respect  of  which 
a  charge  to  a  capital  account  is  made  is  anything  other  than 
money,  the  actual  consideration  shall  be  described  in  the  entry 
with  sufficient  fullness  and  particularity  to  identify  it,  and  the 
amount  charged  shall  be  the  actual  money  value  of  such  con- 
sideration at  the  time  of  the  transaction. 

"Cost  of  labor  includes  not  only  wages,  salaries,  and  fees 
paid  employes,  but  also  such  personal  expenses  of  employes  as 
are  borne  by  the  corporation.  Cost  of  materials  and  supplies 
consumed  in  construction  is  the  cost  at  the  place  where  they 
enter  into  construction,  including  the  cost  of  transportation 
and  inspection  when  specifically  assignable.  If  such  materials 
and  supplies  are  passed  through  storehouses,  their  cost  entered 
in  the  account  may  include  a  suitable  proportion  of  store  ex- 
penses." 

Undoubtedly  the  practice  of  recording  cost  is  the  best  under 
the  prevailing  conditions;  it  preserves  the  most  significant 
figures  and  those  which  all  parties  desire  to  keep.  The  cost  of 
duplication,  or  valuation  upon  the  basis  of  earning  capacity, 
can  be  determined  at  any  time  by  independent  examination,  but 
the  original  cost  can  never  be  determined  if  the  records  fail 
to  show  it.  The  chief  objection  to  this  method  comes  from 
stockholders  who  complain  that  this  does  not  permit  them  to 
enjoy  the  benefits  of  appreciation  of  values.  It  is  not  neces- 
sary at  this  point  to  discuss  the  problem  of  unearned  incre- 
ments of  value,  but  it  may  be  stated  as  a  fact  that  there  is  noth- 
ing in  the  method  which  will  withhold  from  the  stockholders 
the  benefit  of  any  real  and  available  values,  i.e.,  values  which 
they  could  convert  into  cash  and  take  out  of  the  corporate 
enterprise. 

It  is  most  unfortunate  that  any  measure  of  discredit 
should  have  been  cast  upon  the  cost  basis  by  its  supposed  ad- 


242  CAPITALIZATION 

vocates.  In  its  annual  report  for  1908  the  Interstate  Com- 
merce Commission  used  the  following  argument  in  its  plea  for 
a  physical  valuation  of  railroads: 

"A  third  argument  in  support  of  the  plant  as  an  authori- 
tative valuation  of  railway  property  is  found  in  the  present 
unsatisfactory  condition  of  railway  balance  sheets.  The 
balance  sheet  is,  perhaps,  the  most  important  of  the  statements 
that  may  be  drawn  from  the  accounts  of  corporations,  for,  if 
correctly  drawn,  it  contains  not  only  a  classified  statement  of 
corporate  assets  and  corporate  liabilities,  but  it  provides  in  the 
balance,  that  is  to  say,  the  'profit  and  loss,'  a  quick  and  trust- 
worthy measure  of  the  success  that  has  attended  the  operation 
and  management  of  the  property.  Every  balance  sheet  begins 
with  'Cost  of  property,'  against  which  is  set  a  figure  which 
purports  to  stand  for  the  investment.  This  is  no  place  to  enter 
upon  an  extended  criticism  of  the  practice  of  American  rail- 
ways in  the  matter  of  their  property  accounts,  nor  is  such  a 
criticism  necessary  for  the  purpose  in  hand.  It  is  sufficient  to 
refer  to  the  well-known  fact  that  no  court,  or  commission,  or 
accountant,  or  financial  writer,  would  for  a  moment  consider 
that  the  present  balance  sheet  statement  purporting  to  give  the 
'cost  of  property'  suggests,  even  in  a  limited  degree,  a  reliable 
measure  either  of  money  invested  or  of  present  value.  Thus, 
at  the  first  touch  of  critical  analysis,  the  balance  sheets  pub- 
lished by  American  railways  are  found  to  be  inadequate.  They 
are  Incapable  of  rendering  the  service  which  may  rightly  be 
demanded  of  them.  One  cure  seems  possible  for  such  a  situa- 
tion, and  one  only,  and  that  is  for  the  Government  to  make  an 
authoritative  valuation  of  railway  property,  and  to  provide 
that  the  amounts  so  determined  should  be  entered  upon  the 
books  of  the  carriers  as  the  accepted  measure  of  capital  assets. 
Under  no  other  condition  can  the  Commission  complete  in  a 
satisfactory  manner  the  formulation  of  a  standard  system  of 
accounts."  * 

*  Pages  82-83.. 


FIXED    AND    FLOATING   CAPITAL 


343 


It  would  seem  that,  in  the  opinion  of  this  Commission, 
recording  fixed  capital  at  cost  is  only  a  temporary  expedient, 
and  that  recording  values  is  practicable,  provided  the  Com- 
mission is  the  one  to  say  what  that  value  shall  be.  It  seems  to 
overlook  altogether  the  fact  that,  even  if  it  had  all  of  the  au- 
thority of  directors,  stockholders,  courts,  and  legislators,  it 
could  not  control  the  changes  which  would  begin  to  affect  that 
value  even  before  the  pronouncement  of  the  value  as  of  a  par- 
ticular instant  could  be  made. 

§  169.     Necessary  Detail  for  Fixed  Capital  Accounts 

The  bookkeeping  record  should  be  in  as  great  detail  as  neces- 
sary to  identify  as  far  as  practicable  the  several  units  of  struc- 
tures or  equipment,  so  that  the  cost  of  the  plant  used  in  render- 
ing service  to  separate  communities,  or  for  different  kinds  of 
service,  may  be  easily  ascertained.  Very  of  ten.  where  proper 
detail  has  been  neglected  in  the  original  entries,  thousands  of 
dollars  have  been  spent  later  to  ascertain  facts  which  could 
easily  have  been  indicated  in  the  first  instance.  The  report  of 
the  New  York  Public  Service  Commission,  Second  District,  for 
the  year  ended  December  31,  1916,  discusses  this  aspect  of 
fixed  capital  accounting  as  follows : 

"Allocation  of  Fixed  Capital:  In  last  year's  report  it  was 
shown  that  to  the  effective  date  of  the  accounting  orders  of  the 
Commission,  practically  all  of  the  public  service  corporations 
had  but  one  principal  plant  account  to  represent  the  investment 
in  the  business.  With  capital  accounts  of  this  character  the  cor- 
porations do  not  know  the  original  cost  of  their  investment 
devoted  to  the  different  classes  of  their  service,  or  to  the  differ- 
ent localities  served ;  nor  are  they  in  a  position  to  determine  the 
costs  or  the  profits  of  their  different  operations  or  operating 
divisions.  Another  very  important  disadvantage  is  that  the 
lack  of  knowledge  of  the  costs  of  the  various  elements  of  the 
property  makes  it  practically  impossible  for  the  corporations  to 
estimate  with  any  degree  of  accuracy  the  amount  of  the  annual 


344 


CAPITALIZATION 


depreciation  or  amortization  which  is  required,  for  unless  the 
investment  which  should  be  amortized  during  the  life  of  a 
unit  of  property  is  known,  it  is  almost  impossible  to  determine 
the  annual  reservations  from  income  which  should  be  made 
with  respect  to  such  property.  Furthermore,  the  corporations 
are  required  by  the  accounting  orders  of  the  Commission  to 
credit  their  fixed  capital  accounts  in  which  the  former  plant 
accounts  are  now  incorporated  with  the  cost  of  property  re- 
tired. This  means  that  unless  the  cost  of  a  unit  is  estimated 
(which  practice  is  never  satisfactory),  an  analysis  will  have 
to  be  made  of  the  charges  to  fixed  capital  during  the  period 
in  which  it  is  thought  the  property  which  is  to  be  retired  was 
purchased.  Very  often  the  property  to  be  retired  was  bettered 
after  having  been  in  service  several  years,  and  it  therefore 
becomes  necessary  to  inquire  further  into  the  fixed  capital  ac- 
count in  order  to  determine  the  value  at  which  the  property  is 
carried  in  that  account.  Last  year  this  division  reported  that 
in  order  to  correct  this  unsatisfactory  condition  in  their  ac- 
counts, many  corporations  were  analyzing  their  entire  plant 
accounts,  in  order  to  learn  their  investment  in  the  different 
classes  of  property  and  also  in  the  different  localities.  These 
analyses  automatically  eliminate  from  the  investment  account 
amounts  which  represent  property  which  has  gone  out  of  ser- 
vice, and  indicate  other  amounts  which  are  not  properly  repre- 
sentative of  the  investment  in  the  property  devoted  to  the  ac- 
tivities of  the  corporation.  Usually  the  results  of  the  inquiry 
into  the  plant  account  are  brought  into  agreement  with  a 
physical  inventory  of  the  property  in  service.  In  effect,  these 
inquiries  amount  to  a  retroactive  application  of  the  Commis- 
sion's accounting  orders  to  the  earlier  corporate  life  of  the 

properties   involved Practically  all   of  these  analyses 

have  their  inception  with  applications  by  these  corporations  to 
the  Commission  for  authority  to  issue  capital  stock  or  mortgage 
bonds,  to  merge,  consolidate,  or  sell  such  properties.  As  the 
corporations   which  have  not  as  yet   properly  assigned  the 


FIXED   AND    FLOATING   CAPITAL  ^^c 

charges  to  their  plant  accounts  over  the  property  which  they 
represent,  come  to  the  Commission  for  authority  to  issue  capi- 
tal securities,  this  very  important  incjuiry  into  their  capital  ac- 
counts will  receive  attention." 

§  170.     Additions  and  Betterments  Accounts 

Necessarily  the  basis  adopted  for  recording  original  capital 
must  also  serve  as  the  basis  for  recording  additions  and  better- 
ments of  capital.  Additions  are  defined  in  the  Uniform  Sys- 
tems of  Accounts  of  New  York  to  include  "additional  struc- 
tures, facilities,  or  equipment  not  taking  the  place  of  anything 
previously  existing.  Betterments  include  the  enlargement  or 
improvement  of  existing  structures,  facilities  and  equipment." 
Definitions  are  important  in  accounting. 

§  171.     Accounting  for  Fixed  Capital  Withdrawn 

It  seems  too  elementary  to  warrant  emphasis  that  fixed 
capital  accounts  should  show  only  costs  for  the  capital  actually 
in  service,  and  that,  if  any  part  of  the  capital  is  abandoned  or 
retired  from  service,  its  cost  also  should  be  taken  out  of  the 
fixed  capital  accounts.  That  this  has  not  always  been  done  is 
due  to  the  fact  that  incorrect  accounting  has  often  found  cor- 
porations unprepared  to  record  the  retirement  without  greatly 
disturbing  their  accounts.  If  they  have  not  anticipated  the 
retirement  by  making  due  provision  therefor,  in  crediting  the 
fixed  capital  accounts  they  would  have  to  debit  the  profit  and 
loss  accounts,  thereby  reducing  the  apparent  surplus  or  in- 
creasing the  deficit.  In  its  annual  report  for  19 12,  the  New 
York  Public  Service  Commission  for  the  Second  District  said: 

"At  this  time,  however,  some  of  our  railroads  and  other 
corporations  too,  are  undoubtedly  reporting  as  in  service  and 
of  value,  equipment  and  other  property  which  would  be  sent 
to  the  scrap  heap  or  sold  for  junk  or  discarded  as  worthless  but 
for  the  reverence  for  surplus  and  the  desire  to  have  the  busi- 
ness appear  more  prosperous  than  it  is  in  fact." 


346 


CAPITALIZATION 


Moreover,  these  corporations,  when  they  faced  the  neces- 
sity of  retiring  certain  old  capital  and  replacing  it  with  new, 
were  remanded  to  the  expedient  of  paying  for  the  new  out  of 
the  proceeds  of  stocks  or  bonds;  but  investors  are  not  anxious 
to  advance  funds  for  the  purchase  of  capital  which  should 
have  been  anticipated  by  charges  against  the  operating  expenses 
of  past  periods.  To  carry  through  the  expedient,  therefore,  it 
was  necessary  to  represent  the  new  capital  as  an  addition  and 
not  a  replacement,  which  could  be  done  only  by  neglecting 
record  of  the  retirement. 

Through  its  entire  experience,  the  New  York  Commission 
for  the  Second  District  has  uncovered  again  and  again  the  con- 
tinued use  of  this  practice,  describing  one  instance  as  that  of 
an  "apparently  prosperous  company  which  in  the  past  seven 
years  has  been  able  to  practically  rebuild  its  plant  at  a  cost  of 
$175,000,  using  therefor  the  sum  of  $61,000  out  of  surplus 
earnings,  and  which  at  the  end  of  the  period  was  able  to  pay 
its  fixed  charges  and  have  a  surplus  sufficient  to  declare  an 
annual  dividend  of  4  per  cent  upon  its  capital  stock.  In  its 
balance  sheet  this  plant  and  equipment  was  placed  at  the  sum 
of  $651,864,  which  can  scarcely  be  construed  other  than  that 
the  tangible  assets  of  the  corporation  are  carried  upon  its  books 
at  that  value."  ^  And  yet,  excluding  intangibles  and  some 
items  which  were  found  to  have  been  improperly  charged  to 
capital,  out  of  $342,204  supposed  to  represent  its  tangible  capi- 
tal at  least  $55,000  represented  capital  which  had  been  wholly 
abandoned,  scrapped,  or  destroyed. 

"The  plainest  principles  of  good  accounting  require  that 
the  portions  of  the  plant  thus  taken  out  of  existence  should 
have  been  credited  to  capital  at  the  amounts  they  were  charged 
in  the  books  at  the  opening  of  the  company's  books.  Nothing 
of  the  kind  has  been  done;  while  on  the  other  hand  the  new 
work,  which  was  nothing  more  or  less  than  replacement,  has 
been  charged  in  full  to  plant  and  equipment,  so  that  Plant  and 

"  Matter  of  Niagara  Light,  Heat  and  Power  Co.,  z  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  90. 


FIXED   AND    FLOATING   CAPITAL 


347 


Equipment  now  stands  charged  with  the  amount  of  the  old 
work  which  has  been  destroyed  and  taken  out  and  the  cost  of 
the  new  work  which  has  replaced  the  same.  Any  just  and 
correct  statement  of  the  affairs  of  the  company  requires  that 
$55,000  should  be  credited  to  capital;  and  if  this  is  done, 
Plant  and  Equipment,  as  representing  the  tangible  assets,  will 
be  reduced  from  $344,204  to  $288,204." 

A  similar  condition  which  developed  upon  the  investiga- 
tion of  another  application  was  described  as  follows: 

"Examination  of  the  company's  affairs  disclosed  that  it 
commenced  business  March,  1902,  with  a  physical  plant  which 
was  charged  to  Fixed  Capital  in  an  amount  not  precisely  ascer- 
tained but  which  it  is  just  to  assume  was  approximately 
$500,000.  Since  that  date  the  company  has  practically  rebuilt 
its  physical  properties,  the  valuation  placed  by  the  Commis- 
sion's engineer  upon  the  part  remaining  being  $51,000.  The 
company  has  credited  nothing  to  Fixed  Capital  on  account  of 
the  property  thus  displaced  and  destroyed  except  the  sum  of 
$15,617,  the  amount  reahzed  by  it  for  junk  from  such  dis- 
placed plant.  The  remainder  of  the  original  charge  to  Fixed 
Capital  on  account  of  such  displaced  plant  it  still  carried  upon 

its  books  as  an  asset The  value  of  the  replacements  has 

also  been  charged  to  Fixed  Capital,  so  that  both  the  destroyed 
plant  and  the  replacement  thereof  appear  in  the  company's 
balance  sheet  as  assets." 

The  balance  sheet  on  December  31,  1908,  showed  the 
amount  of  fixed  capital  at  $1,302,726,  the  portion  thereof  rep- 
resenting the  destroyed  plant  being  "substantially  40  per  cent 

of  the  whole Such  a  statement  of  assets  is  too  grossly 

misleading  to  those  who  may  be  asked  to  buy  its  stock  or 
bonds  to  be  approved.  Accounts  and  balance  sheets  should 
state  facts  and  are  assumed  to  do  so.  If  this  company  should 
plainly  write  in  its  balance  sheet  the  exact  facts — 'Old  plant 
now  wholly  non-existent,  $500,000' — it  would  be  full  notice  to 
every  one  that  its  affairs  were  in  precisely  the  condition  which 


348  CAPITALIZATION 

would  be  shown  were  it  to  strike  out  the  item  wholly  from 
Fixed  Capital  and  create  a  balance  by  writing  'Deficit, 
$500,000.'  "  ^ 

To  enforce  the  principles  of  correct  accounting  which  the 
Commission  had  in  mind  in  these  cases,  the  accounting  rules 
formulated  by  it  contain  the  following  requirement:  "When 
anything  is  withdrawn  or  retired  from  service,  the  amount 
at  which  such  thing  stood  charged  in  the  capital  account  shall 
be  credited  to  the  capital  account  in  which  it  stood  charged  at 
the  time  of  withdrawal,  and  the  entry  of  such  credit  shall  cite 
by  name  and  page  of  book  or  other  record  the  original  entry  of 

cost  of  the  thing  withdrawn If  such  amount  is  not 

known,  it  shall  be  estimated,  the  facts  upon  which  the  estimate 
is  based  shall  be  shown,  and  the  amount  thus  estimated  to  be 
the  original  charge  in  respect  of  such  thing  withdrawn  shall 
be  credited." 

§  172.     Maintenance  and  Depreciation  of  Fixed  Capital 

Changes  in  fixed  capital  which  must  be  properly  reflected 
in  the  accounts  are  constantly  occurring.  The  designation 
"fixed  capital"  may  convey  the  idea  of  permanency,  but  only 
relative  permanency  is  contemplated  in  the  use  of  the  term. 
"All  machinery  is  on  an  irresistible  march  to  the  junk  heap. 
The  machinery  is  gradually  worn-out  or  consumed  in  the 
process  of  production  precisely  as  the  coal  is  consumed.  The 
consumption  of  the  coal  is  visible  and  apparent.  The  con- 
sumption of  the  machine  is  not  visible,  extends  over  a  term  of 
years  and  through  a  long  series  of  production.  The  cost  of 
the  coal  enters  into  the  cost  of,  we  may  say,  one  article  of  the 
product  of  the  machine.  The  cost  of  the  machine  enters  into 
the  cost  of  thousands  of  the  articles  it  produces.  The  opera- 
tions of  production  ultimately  destroy  both  the  floating  capital 
and  the  fixed  capital  (with  some  few  exceptions,  such  as  land) 


*  Matter   of   Binghamton   Light,   Heat   and   Power   Co.,  2  P.    S.   C.   Rep.    (2nd    D., 
N.   Y.)    171.     First  part  of  quotation  is   from   headnote. 


FIXED    AND    FLOATING    CAPITAL  349 

concerned  in  such  operations.  In  one  the  destruction  is  im- 
mediate; in  the  other  it  is  slow  and  spread  over  a  series  of 
years."  ^ 

Maintenance  expenses  are  those  which  record  the  current 
consumption  of  fixed  capital.  They  are  the  accounts  which 
carry  to  the  cost  of  the  product  the  value  of  the  fixed  capital 
consumed  in  the  process  of  manufacture. 

If  the  use  of  the  fixed  capital  is  to  be  indefinitely  continued, 
it  must  be  continually  kept  at  its  utmost  operating  efficiency 
which,  presumably,  is  the  measure  of  its  performance  when 
installed  new;  thus  there  must  be  constant  observation  of  the 
destruction  caused  by  operations  and  the  destroyed  parts  must 
be  replaced.  No  man  will  buy  a  suit  of  clothes  and  expect  to 
wear  it  any  length  of  time  without  giving  some  attention  to  the 
maintenance  of  its  condition  and  appearance.  But,  even  then, 
no  matter  how  much  care  he  exercises  in  the  use  of  these 
clothes,  keeping  them  cleaned,  pressed,  and  repaired,  he  will 
not  be  able  to  wear  them  throughout  his  entire  life — sooner 
or  later  the  clothes  will  wear  out;  or,  if  made  of  such  good 
material  as  to  last  a  long  time,  the  man  will  outgrow  his  clothes 
or  let  them  outgrow  him,  so  that  in  the  end  he  will  have  to 
abandon  them.  Fixed  capital  bears  the  same  relation  to  the 
business  as  clothes  do  to  the  man  in  this  respect.  It  will  get 
old;  there  will  be  wear  and  tear  which  will  never  be  made 
good  through  repairs;  if  happily  its  life  be  capable  of  great 
prolongation,  the  business  will  outgrow  the  capital.  Through 
the  progress  of  the  art  or  through  expansion  of  the  business 
the  capital  may  become  obsolete  and  utterly  inadequate,  so  that, 
like  the  clothes,  it  will  need  to  be  abandoned,  to  be  replaced 
with  other  capital.  It  does  not  become  worn-out  all  of  a  sud- 
den, except  as  it  is  destroyed  by  accident,  such  as  fire,  flood,  or 
other  casualty;  nor  does  it  become  obsolete  or  inadequate  in 
the  twinkling  of  an  eye.    When  abandonment  becomes  neces- 


''  Refer  to  quotation  in  §   167  of  this  chapter  from  opinion  in  Matter  of  Binghamton 
Light,  Heat  and  Power  Co. 


350 


CAPITALIZATION 


sary  it  is  the  result  of  a  process  just  as  sure  as  the  more  ap- 
parent one  of  reparable  wear  and  tear,  and  the  expenses  en- 
tailed in  this  process  are  just  as  much  costs  of  production  as 
any  other  maintenance  expenses.  This  process  is  described  as 
depreciation.  Technically,  depreciation  should  include  the  en- 
tire process  of  the  destruction  or  consumption  of  fixed  capital 
in  the  productive  process  whether  the  wear  and  tear  is  repara- 
ble or  not ;  however,  it  is  understood  in  most  cases  to  indicate 
the  irreparable  wear  and  tear  and  the  loss  in  value  through 
obsolescence  and  inadequacy. 

§  173-     (i)  Relative    Importance    of    Maintenance    Expense 
Accounts 

Maintenance  expenses  constitute  a  very  important  group 
in  the  operating  expenses  of  public  utilities.  Proper  practice 
in  this  respect  is  therefore  very  essential  to  accuracy  in  the 
statement  of  earnings  and  surplus.  For  the  sake  of  classifica- 
tion we  may  think  of  maintenance  expenses  as  representing 
three  conditions.  First,  imperative  maintenance  or  repairs 
which  must  be  made  forthwith  if  the  machine  or  other  appara- 
tus is  to  be  kept  in  use ;  the  breaking  of  a  bolt  or  of  a  wheel 
will  incapacitate  a  locomotive  and  the  broken  parts  must  be 
replaced  immediately  in  order  not  to  lose  the  entire  investment 
in  the  apparatus.  Second,  optional  maintenance,  or  restoration 
of  deterioration  which  should  be  made  good  but  the  need  for 
which  is  not  compelling,  e.g.,  reballasting  roadbed,  repainting 
structures,  etc.  Third,  depreciation  through  irreparable  wear 
and  tear,  obsolescence,  and  inadequacy. 

These  are  classifications  in  degree  only  and  the  lines  of 
division  are  indefinite;  for  instance,  optional  maintenance,  if 
long  neglected,  will  soon  become  imperative.  The  classification 
is  important,  however,  in  its  bearing  upon  the  manipulation  of 
maintenance  accounts.  In  the  case  of  imperative  maintenance 
the  company  has  little  choice  in  making  the  expenditure ;  on 
the  other  hand,  the  expediency  of  repairs  which  come  within 


FIXED   AND   FLOATING   CAPITAL  351 

the  class  of  optional  maintenance  has  very  often  been  deter- 
mined not  by  the  physical  facts,  but  by  the  condition  of  the 
expense  accounts  and  the  desirability  of  keeping  them  within 
such  limits  as  will  permit  satisfactory  earnings  to  be  shown 
for  that  period,  in  the  hope  that  the  operations  of  the  follow- 
ing period  will  be  sufficiently  better  not  only  to  stand  their 
own  maintenance  burden  but  also  those  brought  over  from 
preceding  periods.  Within  certain  limits,  of  course,  some  kinds 
of  optional  maintenance  are  properly  subject  to  considerations 
of  expediency;  the  repainting  of  a  structure,  for  instance,  may 
sometimes  well  depend  on  circumstances  as  to  whether  it  should 
be  done  this  year  or  next.  The  unfortunate  results  of  subordi- 
nating maintenance  to  other  considerations  are  too  apparent 
to  require  description ;  the  decreased  efficiency  caused  by  neg- 
lecting repairs  increases  total  expenses  by  more  than  the 
amount  which  was  required  for  the  repairs  when  the  wear 
first  became  noticeable,  to  say  nothing  of  the  deterioration  in 
service  which  is  bound  to  follow.  Should  the  expectation  of 
sufficiently  improved  operations  in  succeeding  periods  prove 
to  be  ill-founded,  the  results  will  be  disastrous. 

§  174.     (2)  Depreciation  Accounts 

The  complete  neglect  of  accounting  for  maintenance  ex- 
penses of  the  third  class,  to  wit,  depreciation  through  irrepa- 
rable wear  and  tear,  obsolescence,  and  inadequacy,  is  almost  as 
often  the  result  of  ignorance  as  of  intent.  But  where  depre- 
ciation charges  are  regularly  included  in  the  accounts,  it  is  of 
the  greatest  importance  that  the  method  of  ascertaining  the 
amounts  be  a  correct  one ;  slight  changes  in  the  method  may 
produce  great  fluctuations  in  the  maintenance  accounts.  There 
are  few  subjects  in  accounting  which  have  caused  as  much  dis- 
cussion as  that  of  depreciation.  The  literature  on  this  subject 
is  increasing  annually,  but  the  progress  toward  unanimity  as 
to  method  of  procedure  is  very  slow.  In  the  first  place  there 
is  no  unanimity  of  opinion  that  depreciation  should  be  taken 


352 


CAPITALIZATION 


into  the  accounts  at  all,  beyond  that  which  is  subject  to  current 
maintenance,  so  that  if  the  property  is  maintained  to  standard 
the  consumption  of  capital  is  sufficiently  absorbed  by  the  costs 
of  production.  Then,  even  where  the  necessity  of  recording 
depreciation  is  admitted,  there  is  great  diversity  of  opinion  as 
to  the  methods  used  in  ascertaining  its  amount,  the  factors  to 
be  considered,  etc. 

To  support  the  claim  that  it  is  unnecessary  to  take  up 
formal  depreciation  charges  to  record  the  consumption  of  capi- 
tal, beyond  that  recognized  in  the  current  maintenance  ex- 
penses, it  is  contended  that  there  can  be  no  measure  of  the  loss, 
and  that  any  attempt  to  determine  the  loss  will  be  arbitrary  and 
consist  of  mere  estimates.  The  question  of  estimates  forming 
the  basis  of  depreciation  charges  has  proved  the  stumbling 
block  to  many  who  contend  that  the  operating  expense  accounts 
should  reflect  facts  and  that  they  have  no  business  with  guess- 
work. But  depreciation  is  an  unquestioned  fact;  in  the  car- 
bonization of  coal  for  gas-making  purposes,  for  instance,  the 
fractional  consumption  of  the  apparatus  utilized  is  as  indubita- 
ble a  fact  as  is  the  consumption  of  the  coal.  Even  those  who 
argue  against  formal  depreciation  charges  cannot  deny  the 
fact  of  depreciation.  The  matter  to  be  estimated  is  not  the 
depreciation  itself,  whether  any  exists  or  not — a  fact  readily 
ascertainable — but  the  amount  of  the  money  loss  involved  if 
there  is  depreciation.  The  fact  of  depreciation  once  admitted, 
the  logical  conclusion  is  that  an  effort  should  be  made  to  de- 
termine its  amount,  and  if  exact  determination  is  not  practica- 
ble and  only  a  possible  approximation  can  be  had,  it  is  far  better 
to  accept  the  approximation  and  make  charges  accordingly 
than  it  is  to  ignore  the  fact  altogether.  It  is  further  urged, 
however,  that  a  correct  statement  of  net  revenue  is  in  danger 
quite  as  much  by  an  overcharge  as  by  an  undercharge  to  oper- 
ating expenses,  and  that,  since  a  charge  for  depreciation  must 
rest  so  largely  upon  estimates,  it  is  possible  that  the  estimate 
may  call  for  a  charge  of  an  amount  greater  than  is  necessary, 


FIXED   AND    FLOATING   CAPITAL 


353 


SO  that  the  net  revenue  may  be  understated.  The  objection  has 
some  merit,  but  its  vaHdity  and  force  extend  only  to  the  need 
of  great  care  in  making  the  estimate  and  not  to  the  fact  of 
depreciation  itself.  It  will  not  be  long  before  any  gross  errors 
in  the  approximations  will  become  manifest  and  can  be  cor- 
rected, so  that  little  by  little  the  approximations  will  more 
nearly  correspond  to  the  facts  as  they  are. 

It  is  not  necessary  to  review  further  the  arguments  for  or 
against  formal  depreciation  accounts;  it  is  sufficient  to  note 
that  they  are  required  almost  uniformly  by  all  public  service 
commissions  in  their  respective  states  as  well  as  by  the  Inter- 
state Commerce  Commission. 

§  175'     (3)  Method  of  Recording  Depreciation 

The  consumption  of  fixed  capital  is  a  slow  process  which 
goes  on  constantly ;  when  the  need  for  repairs  becomes  appar- 
ent, except  that  caused  by  accident,  it  is  only  an  indication  that 
a  certain  stage  has  been  reached  in  this  slow  process.  It  has 
been  thought  desirable  by  some  accountants  to  devise  a  system 
which  will  reflect  in  the  operating  expenses  the  consumption 
of  capital  even  before  the  repairs  are  made,  thus  equalizing 
expenses  and  profits  of  various  periods  and  obviating  the  pos- 
sibility of  manipulation  through  postponement  of  optional 
maintenance.  If  the  entire  consumption  is  to  be  reflected,  the 
depreciation  also  must  be  included.  This  theory  has  been  given 
effect  in  the  accounting  orders  of  the  New  York  Public  Service 
Commission  for  the  Second  District ;  for  instance,  the  instruc- 
tions of  the  accounting  order  for  telephone  corporations  are 
as  follows: 

"Every  telephone  corporation  shall  include  in  its  expenses 
depreciation  charges  for  the  purpose  of  creating  proper  and 
adequate  reserves  to  cover  expenses  of  depreciation  currently 
accruing  in  Its  fixed  capital.  By  'expense  of  depreciation'  is 
meant  the  loss  suffered  through  the  current  lessening  in  value 
of  tangible  property  from  wear  and  tear,  decay,  obsolescence, 


354 


CAPITALIZATION 


or  inadequacy  resulting  from  use,  age,  physical  change,  or 
supersession  by  reason  of  new  inventions  and  discoveries, 
changes  in  popular  demand,  or  pubUc  improvements;  also 
losses  suffered  through  destruction  of  property  by  extraordi- 
nary casualties  and  decreases  in  the  value  of  intangible  prop- 
erty through  the  lapse  of  time. 

"The  amount  charged  as  expense  of  depreciation  shall  be 
based  upon  rules  determined  by  the  accounting  corporation. 
.  .  .  .  The  rates  of  depreciation  should  be  fixed  so  as  to 
distribute,  as  nearly  as  may  be  possible,  evenly  throughout  the 
life  of  the  depreciating  property  the  burden  of  repairs  and  the 
cost  of  capital  consumed  in  operations  during  a  given  month 
or  year  and  should  be  based  upon  the  average  life  of  the  units 
comprised  in  any  class  of  property." 

The  accounting  method  to  carry  out  this  theory  is  to  set  up 
a  depreciation  account  in  operating  expenses,  with  a  corre- 
sponding depreciation  reserve  which  will  appear  on  the  balance 
sheet  as  a  reservation  of  earnings.  The  amount  estimated  to 
cover  the  consumption  of  capital  during  the  period  will  then 
be  debited  to  the  depreciation  account  and  credited  to  the  re- 
serve; when  repairs  are  made  the  cost  of  repairs  will  be  cred- 
ited to  the  depreciation  account  and  debited  to  the  reserve, 
leaving  in  both  accounts  a  balance  which  will  represent  the 
consumed  capital  not  made  good.  The  balance  of  the  depre- 
ciation account  will  be  closed  out  into  operating  expenses,  while 
the  balance  of  the  reserve  will  be  a  deduction  from  the  fixed 
capital  account.  The  form  of  a  balance  sheet  will  sometimes 
show  the  actual  deduction  of  the  balance  of  the  reserve  from 
the  fixed  capital  account  on  the  asset  side  of  the  balance  sheet, 
while  other  forms  will  not  disturb  the  asset  side  at  all  but  will 
include  the  depreciation  reserve  on  the  liability  side.  The  use 
of  the  reserve  account  does  away  with  any  credits  direct  to  the 
fixed  capital  accounts  for  accrued  depreciation.  The  method 
of  crediting  depreciation  direct  to  the  fixed  capital  accounts  is 
objectionable,  for  it  tends  to  destroy  the  integrity  of  the  fixed 


FIXED   AND    FLOATING    CAPITAL 


355 


capital  accounts  which  will  cease  to  indicate  a  clear-cut  and 
definite  fact,  to  wit,  the  cost  of  the  capital  in  service. 

§  176.     (4)  Over-  or  Under-Statement  of  Maintenance  to  Be 
Avoided 

Maintenance  expenses  are  sometimes  overstated  by  charges 
for  new  capital  which  should  properly  have  been  carried  to 
the  fixed  capital  accounts ;  on  the  other  hand,  they  may  be  un- 
derstated by  the  diversion  to  fixed  capital  accounts  of  repair 
or  replacement  charges  which  should  have  been  made  to  oper- 
ating expenses.  Sometimes  it  is  attempted  to  exclude  tempo- 
rarily repair  costs  from  the  statement  of  operating  expenses 
for  any  one  period  by  holding  them  in  abeyance,  charging  them 
to  a  suspense  account  which  will  in  the  meantime  appear  among 
the  assets  on  the  balance  sheet.  Under  very  special  circum- 
stances this  practice  may  be  permissible,  as  for  instance,  when 
extraordinarily  heavy  expenses  are  incurred  through  unex- 
pected and  unusual  casualties ;  it  must  be  used  with  great  care, 
however,  for  it  can  easily  be  made  the  means  of  deception. 

§  177.     Accounting  for  Replacements  of  Capital 

Repairs  constituting  maintenance  must  not  be  confused 
with  replacements.  The  Uniform  Systems  of  Accounts  of 
the  PubHc  Service  Commissions  of  New  York  define  these 
terms  thus: 

"When  through  wear  and  tear  or  through  casualty  it  be- 
comes necessary  to  replace  some  part  of  any  structure,  facility, 
or  unit  of  equipment  and  the  extent  of  such  replacement  does 
not  amount  to  a  substantial  change  of  identity  in  such  struc- 
ture, facility  or  unit  of  equipment,  the  replacement  of  such  part 
is  to  be  considered  a  repair,  and  the  cost  of  such  repair  is  to  be 
treated  as  an  operating  expense  and  must  not  be  charged  as 
a  replacement  in  capital  accounts. 

"Replacements  include  all  substitutions  for  capital  ex- 
hausted or  become  inadequate  in  service,  the  substitute  having 


356  CAPITALIZATION 

substantially  no  greater  capacity  than  that  for  which  it  is  sub- 
■  stituted.  When  a  substitute  has  a  substantially  greater  capacity 
than  that  for  which  it  is  substituted,  the  cost  of  a  substitution 
of  one  of  the  same  capacity  as  the  thing  replaced  should  be 
charged  as  a  replacement  and  the  remaining  portion  of  the  cost 
of  the  actual  substitute  should  be  charged  as  a  betterment." 

The  practice  contemplated  in  the  above  instructions  carries 
the  accounting  for  replacements  through  the  capital  accounts. 
The  original  cost  of  the  capital  replaced  must  be  credited  to 
capital  account  as  having  been  retired,  and  the  cost  of  the  new 
and  replacing  capital  must  be  charged  at  cost  as  having  been 
installed.  It  is  assumed  that  the  company  will  have  provided 
through  its  depreciation  accounts  for  replacement  to  the  extent 
of  the  cost  of  the  capital  retired,  less  the  expected  salvage.  If 
the  cost  of  the  replacing  capital  is  the  same  as  that  of  the  capi- 
tal retired,  the  net  effect  of  the  accounting  is  the  same  as  though 
the  replacement  had  been  carried  through  operating  expense 
accounts  altogether.  If  the  cost  of  the  new  is  greater,  even 
though  the  article  is  exactly  the  same  as  that  which  it  replaces, 
the  excess  cost  goes  to  increase  the  investment  in  fixed  capital. 
This  practice  has  not  gone  unchallenged. 

The  replacement  of  the  whole  unit  because  it  has  become 
worn-out  is  not  different  from  the  replacement  of  its  several 
parts,  and  it  may  be  plausibly  argued  that  if  the  replacement 
of  the  parts  goes  into  operating  expenses  at  cost  of  making  the 
replacement,  the  cost  of  replacing  the  unit  itself  should  be 
similarly  treated.  There  is,  however,  a  very  good  reason  for 
distinguishing  between  the  replacement  of  parts  and  the  re- 
placement of  the  unit.  If  cost  is  to  be  the  basis  of  the  capital 
accounts,  then  those  accounts  should  show  the  last  cost.  If 
assets  which  originally  cost  $100,000  on  renewal  have  cost 
$125,000,  the  increased  cost  should  be  charged  to  the  fixed 
capital  accounts  so  that  the  burden  of  the  excess  cost  shall  not 
be  charged  against  the  ratepayers  of  one  period  only,  as  would 
be  the  case  if  the  costs  were  treated  as  costs  of  repairs,  but  be 


FIXED    AND    FLOATING   CAPITAL 


357 


distributed  among  the  consumers  of  the  service  in  which  the 
new  unit  at  its  increased  cost  is  utiHzed. 

It  is  perhaps  true  that  heretofore  the  more  favored  basis  of 
accounting  for  replacements  has  been  that  which  treats  the  cost 
of  replacing  in  kind  as  an  operating  expense  solely,  no  matter 
how  much  greater  than  original  cost  this  cost  of  the  replacing 
article  may  be.  If  there  is  any  element  of  betterment,  a  pro- 
portion of  the  cost  applicable  to  the  betterment  is  properly 
subject  to  capitalization.  The  betterment  must  be  represented 
by  greater  capacity,  or  perhaps  by  advanced  construction  which 
makes  operations  more  economical.  The  test  is  that  of  an  in- 
crease in  earning  capacity  on  the  theory  that,  if  the  betterment 
is  charged  to  capital,  the  expenditure  will  probably  be  met  out 
of  additional  stock  and  bond  issues.  The  increase  in  dividend 
and  interest  charges  thus  caused  should  be  paid  out  of  the 
earnings  of  the  betterment. 


CHAPTER    XVII 

ISSUE  OF  STOCKS  AND  BONDS  FOR  ACQUISITION 
OF  FIXED  CAPITAL 

§  178.     Fixed  Capital  Classified 

The  Uniform  Systems  of  Accounts  prepared  by  the  Public 
Service  Commissions  of  New  York  divide  fixed  capital  into 
landed  capital  and  non-landed  capital.  "Landed  capital  in- 
cludes all  interests  in  land  (exclusive  of  improvements 
thereon)  the  term  of  which  is  more  than  one  year.  All  other 
fixed  capital  is  herein  called  non-landed  capital."  They  further 
divide  non-landed  capital  into  intangible  and  tangible,  defining 
the  terms  as  follows: 

"Intangible  capital  comprises  organization,  franchises,  pat- 
ent rights,  and  all  other  intangible  property  within  the  defini- 
tion of  fixed  non-landed  capital  as  above  stated.  Tangible 
capital  comprises  structures  and  equipment  having  an  expecta- 
tion of  life  in  service  of  more  than  one  year." 

§  179.     Capitalization  for  Acquisition  of  Intangible  Capital 

Under  the  head  of  intangible  capital  can  be  discussed  in 
order:  (i)  organization  expenses ;  (2)  franchises;  (3)  pat- 
ent rights;  (4)  contract  rights  and  other  intangible  capital. 
These  are  intended  to  represent  rights  and  claims  conferring 
value  upon  the  corporate  enterprise ;  they  are  assumed  to  be 
capital  in  and  of  themselves,  and  not  merely  expenditures  inci- 
dent to  the  acquisition  of  physical  property,  so  that  they  are 
not  to  be  confused  with  expenditures  on  such  items  as  en- 
gineering, interest  during  construction,  etc.  There  are  not 
included  herein  investments  in  stocks,  bonds,  commercial  paper, 
and  other  evidences  of  interest  which,  although  constituting 

358 


ACQUISITION    OF   FIXED    CAPITAL  359 

intangible  capital  in  a  broad  sense  of  the  term,  do  not  come 
within  the  scope  of  the  restricted  sense  in  which  the  term  is 
here  used,  to  wit,  capital  used  by  the  corporation  in  the  rendi- 
tion of  a  particular  service. 

The  discussion  of  depreciation  in  Chapter  XVI  referred 
mainly  to  loss  in  value  of  the  tangible  capital  in  service.  There 
is  also  depreciation  of  intangible  capital.  Where  rights  are 
limited  to  a  number  of  years,  the  amounts  charged  to  fixed 
capital  accounts  in  respect  thereof  should  be  amortized  during 
the  life  of  such  rights,  unless  it  is  expected  that  upon  expiration 
they  can  and  will  be  renewed.  If  that  renewal  may  be  accom- 
plished without  further  expense,  the  original  charge  to  capital 
accounts  will  remain  as  the  cost  of  acquiring  that  right.  If 
further  expense  is  involved,  the  renewal  cost  could  either  be 
carried  through  the  operating  accounts  or  handled  through 
fixed  capital  accounts,  according  to  the  method  prescribed  for 
the  recording  of  replacements  of  capital. 

§  180.     (i)  Organization  Expenses 

These  expenses  are  those  which  relate  to  the  organization 
of  the  corporate  structure  itself,  from  the  time  that  the  idea 
is  first  suggested  to  the  promoters  and  actively  taken  up  by 
them,  to  the  time  when  the  incorporation  has  become  an  ac- 
complished fact  and  its  project  has  been  launched ;  that  is  to 
say,  until  all  necessary  papers  have  been  filed,  the  requisite 
authorizations  acquired,  prospective  investors  canvassed,  stock 
and  bond  certificates  prepared,  sold,  and  delivered  to  the  pur- 
chasers, and  the  proceeds  entrusted  to  the  corporate  treasury. 
Later  on,  changes  may  occur  in  this  corporate  structure;  its 
capitalization  may  be  increased,  its  powers  extended,  etc. ;  and 
the  expenses  attending  these  changes  will  also  become  organ- 
ization expenses. 

All  of  the  expenses  here  described  are  generally  included 
under  the  head  of  intangible  capital,  but  none  of  them  represent 
costs  which  can  be  said  to  represent  the  acquisition  by  the  cor- 


360  CAPITALIZATION 

poration  of  any  property  or  other  valuable  rights.  The  cor- 
-  poration  exists  by  virtue  of  a  privilege  extended  to  incorpora- 
tors; the  corporation  itself  may  be  said  to  be  a  franchise  which 
belongs  to  the  members  of  that  corporation.  Hence,  the  ex- 
penses of  organizing  the  corporation  are  costs  suffered  by  the 
incorporators  and  their  successors  in  interest  in  perfecting  and 
maintaining  their  claim  to  a  privilege  intended  to  be  used  for 
personal  profit  to  themselves.  That  privilege  is  assumed  to  be 
valuable  to  its  possessors,  hence  the  exaction  and  the  willing 
submission  to  the  payment  of  an  organization  tax.  In  strict 
theory,  therefore,  there  would  seem  to  be  no  good  reason  why 
the  stockholder  should  be  relieved  from  these  expenses.  It  is 
probably  because  of  reasoning  such  as  this  that  the  German  and 
Swiss  laws  specifically  prohibit  the  inclusion  of  these  items  in 
fixed  capital  accounts,  or  their  disbursement  out  of  stock  and 
bond  issues,  so  that  it  is  customary  there  to  issue  capital  stock 
above  par  in  order  to  collect  an  amount  sufficient  to  cover  the 
organization  expenses ;  in  effect,  the  stockholders  are  assessed 
for  their  proportionate  share  of  the  expenses. 

In  our  public  utility  practice,  however,  there  is  very  good 
reason  for  including  organization  expenses  in  the  fixed  capital 
accounts  of  the  corporation.  Even  though  it  is  an  expense  not 
producing  actual  assets  to  the  corporation,  and  even  though 
it  is  said  to  be  wholly  for  the  benefit  of  the  individual  stock- 
holder, it  is  nevertheless  an  expenditure  which  is  entitled  to  a 
return,  since  it  has  been  incurred  to  establish  the  project.  The 
emphasis  that  has  been  placed  of  late  years  upon  the  invest- 
ment of  the  stockholders  as  a  basis  for  rate-fixing  tends  to 
strengthen  the  warrant  for  the  inclusion  of  organization  ex- 
penses in  capital  accounts,  so  that  the  actual  cost  of  the  cor- 
porate project  may  be  set  forth.  Since  the  profits  of  the  enter- 
prise accrue  directly  to  the  corporation,  it  is  only  fair  that  the 
corporation  should  assume  the  expenses  incurred  by  incorpor- 
ators in  initiating  that  enterprise. 

In  spite  of  the  fact  that  the  right  to  be  a  corporation  is  a 


ACQUISITION    OF   FIXED    CAPITAL  361 

privilege  of  the  stockholders  alone,  it  has  not  been  uncommon 
for  corporations  to  inflate  their  fixed  capital  accounts  and  cap- 
italization by  placing  a  high  valuation  upon  "organization." 
Against  that  high  valuation  they  would  issue  additional  stocks 
and  bonds  to  cover  up  accrued  deficits,  or  else  to  declare  and 
distribute  dividends  in  the  form  of  stock,  scrip,  etc.  So  com- 
mon has  been  the  use  of  this  device  that  it  has  been  thought 
necessary  to  make  specific  provision  therefor.  The  New  York 
Public  Service  Commissions  law  provides  that  "the  Commis- 
sion shall  have  no  power  to  authorize  the  capitalization  of  any 
franchise  to  be  a  corporation."  This  prohibition  has  not  been 
held  to  affect  capitalization  of  the  organization  expenses. 

Expenses  of  Effecting  Corporate  Organization.  This  group 
of  organization  expenses  includes  the  cost  of  preparing  the 
certificate  of  incorporation,  including  the  compensation  of  at- 
torneys and  others,  costs  of  recording,  and  all  other  costs  inci- 
dent to  the  perfection  of  the  right  to  be  a  corporation.  The 
organization  tax  which  in  New  York  and  in  practically  every 
other  state  is  required  to  be  paid  before  or  coincident  with  the 
filing  of  the  certificate  is  also  a  part  of  these  expenses.  There 
are  also  included  herein  all  costs,  such  as  compensation  of 
counsel  and  expenses  of  expert  and  other  witnesses,  of  appli- 
cations for  authority  to  begin  construction  and  to  engage  in 
business  in  the  territory  intended  to  be  served.  This  last  item 
of  costs  may  sometimes  reach  high  figures,  especially  if  the 
application  is  opposed;  nevertheless,  if  the  applicant  is  suc- 
cessful, the  total  costs  are  chargeable  to  the  fixed  capital  ac- 
counts under  the  prevailing  rules,  although  it  is  quite  probable 
that  it  is  within  the  powers  of  a  commission  to  require  these 
costs  to  be  amortized  in  whole  or  in  part  out  of  earnings.  The 
contesting  company,  of  course,  if  already  operating,  could  not 
carry  the  expenses  of  the  contest  to  capital  accounts,  even 
though  it  might  be  the  successful  party  and  secure  its  undis- 
turbed possession. 

Most  of  these  expenses  have  become  matters  of  record  by  the 


362  CAPITALIZATION 

time  authorization  for  capital  stock  and  bonds  is  granted,  while 
the  remainder  may  be  almost  exactly  anticipated.  There  will 
thus  be  very  little  discussion  concerning  the  amount  to  be  in- 
cluded in  the  total  sum  to  be  provided  for  in  the  proposed  capi- 
talization. 

It  goes  without  saying  that  no  duplication  can  be  permitted 
in  these  accounts ;  for  instance,  a  corporation  which  has  merged 
another  into  itself  cannot  take  over  the  organization  accounts 
of  that  other  and  also  charge  to  capital  account  the  costs  of 
effecting  the  merger.  Neither  may  a  consolidated  corporation 
take  over  the  accounts  of  the  consolidating  corporation  and 
also  charge  to  capital  the  costs  of  consolidation,  even  though  in 
the  latter  case  it  is  contended  that  the  expenses  of  consolida- 
tion were  incurred  to  secure  definite  operating  economies  so 
that  they  may  be  said  to  represent  a  betterment. 

Expenses  of  Corporate  Financing.  The  expenses  attending 
the  issue  of  capital  stock  are  those  incurred  in  the  preparation 
of  prospectuses;  the  commissions  paid  to  underwriters;  the 
costs  of  preparing  certificates ;  etc.  These  are  considered  to  be 
expenses  of  acquiring  the  permanent  capital  fund;  the  costs 
of  the  properties  and  rights  acquired  with  the  proceeds  of  the 
stock  issue  may  therefore  be  said  to  have  been  increased  by  the 
expense  of  securing  the  issue  of  the  stock,  so  that  these  costs 
may  be  charged  to  capital  accounts. 

The  status  of  bond  discount  and  expense  is  sometimes 
thought  to  be  analogous  to  that  of  stock  expense  and  chargea- 
ble to  fixed  capital  accounts  in  similar  manner.  Such  is  not 
the  fact,  however;  there  is  no  unmistakable  likeness.  Bond 
expense  includes  the  expenses  of  having  the  mortgage  drawn 
up,  titles  searched,  certificates  prepared,  etc.,  and  the  commis- 
sions paid  to  underwriters  or  brokers.  The  total  bond  dis- 
count and  expense  is  a  cost  of  borrowing,  which  some  would 
have  considered  as  identical  in  nature  with  the  costs  of  acquir- 
ing the  permanent  capital  fund  through  stock  issues.  The 
issue  of  stock  is  a  necessary  part  of  the  organization  of  the 


ACQUISITION    OF   FIXED   CAPITAL  363 

corporation;  the  borrowing  of  money  is  an  incident  in  the 
operation  of  the  fully  organized  corporation  and  is  a  transac- 
tion between  it  and  third  parties.  The  main  distinction  arises, 
of  course,  out  of  the  limitation  usually  placed  upon  the  life  of 
the  bonds,  while  the  life  of  stock  will  be  contemporaneous  with 
that  of  the  corporation.  The  bond  discount  and  expense  relat- 
ing to  issues  of  irredeemable  bonds  or  those  running  for  extra- 
long-term  periods  may  very  plausibly  be  charged  to  capital 
accounts  in  the  same  manner  as  expenses  relating  to  the  issue 
of  stock. 

The  Uniform  Systems  of  Accounts  of  the  New  York  Pub- 
lic Service  Commissions  specifies  that  "discounts  upon  securi- 
ties and  other  commercial  paper  issued  in  payment  for  capital 
are  to  be  provided  for  in  other  accounts  and  must  in  no  case 
be  charged  to  the  capital  accounts."  The  method  prescribed 
is  in  Hne  with  an  interpretation  of  "cost  of  borrowing"  to 
include  both  the  interest  actually  paid  upon  the  bonds  together 
with  the  discount  suffered,  and  the  expenses  incurred  in  the 
issue.  The  total  bond  discount  and  expense  must  be  carried  in 
suspense  and  amortized  through  income  during  the  life  of 
the  securities  to  which  they  relate,  so  that  for  each  year  the 
interest  payments  plus  the  proportion  of  bond  discount  and 
expense  charged  ofif  will  represent  the  total  payment  for  the 
use  of  borrowed  capital.  The  accounting  method  has  already 
been  described  in  Chapter  X. 

Those  who  would  treat  bond  discount  and  expense  as  identi- 
cal with  the  expense  attending  the  issue  of  stock,  contend  that 
these  are  costs  of  getting  the  tangible  capital  actually  placed  in 
service  so  that  they  represent  just  as  much  an  investment  as 
expenditures  for  rails  or  ties,  buildings,  etc.  The  American 
Street  and  Interurban  Railway  Accountants'  Association,  in  re- 
porting upon  a  standard  classification  of  accounts  prepared 
more  or  less  in  conjunction  with  representatives  of  the  Inter- 
state Commerce  Commission  in  1908,  said:  "The  committee 
is  uniformly  of  the  opinion,  that  discounts  and  commissions  on 


364  CAPITALIZATION 

securities  issued  for  construction  purposes,  or  to  raise  funds 
for  construction,  should  be  considered  a  proper  capital  expendi- 
ture and  therefore  to  be  charged  to  Expenditures  for  Road  and 
Equipment."  The  Interstate  Commerce  Commission  has  ap- 
parently recognized  some  merit  in  this  contention,  or  at  least 
has  not  found  sufficient  demerit  to  condemn  it  in  toto,  since 
its  accounting  orders  permit  the  charge  to  capital  of  "cost  of 
printing  certificates  of  stock  and  bonds,  with  payments  to 
trustees  and  expenses  incurred  in  the  disposal  of  the  securities." 

In  determining  the  amount  of  bonds  necessary  to  be  issued, 
the  commission  obviously  must  consider  the  price  at  which  the 
bonds  are  to  be  sold  in  order  to  arrive  at  the  gross  amount 
necessary  to  be  authorized.  In  passing  upon  the  price  of  issue 
it  will  inquire  fully  into  contracts  with  bankers  or  underwriters, 
require  proof  of  market  quotations  for  securities  of  similar 
character,  and  conduct  any  further  inquiry  to  satisfy  itself  as 
to  the  reasonableness  of  the  proposed  price  of  issue.  The  dis- 
count to  be  suffered  is  thus  fairly  fixed  in  arriving  at  the  capi- 
talization to  be  authorized,  while  other  expenses  of  the  issue 
of  stock  or  bonds  can  easily  be  ascertained. 

Promoters'  Fees.  To  many  people  payment  of  "promoters' 
fees"  suggests  the  extreme  of  corporate  sinfulness.  There  is 
no  question  that  there  have  been  instances  which  could  not  be 
described  any  more  appropriately  than  by  such  characteriza- 
tions, but  there  have  also  been  innumerable  instances  where  the 
promoters  have  conferred  upon  the  public  distinct  and  valua-^ 
ble  service,  for  which  they  have  been  but  ill  repaid.  The  num- 
ber of  those  who  have  spent  their  all,  their  very  selves,  in  the 
development  of  enterprises  which  proved  public  boons  but 
which  brought  naught  but  loss,  reproach,  and  ruin  to  their 
promoters,  is  great  indeed. 

"Promotion  has  been  so  extensively  abused  and  has  been 
so  universally  used  as  a  cover  for  abuses  in  capitalization  that 
it  has  come  to  be  regarded  as  a  term  of  reproach  and  as  a 
device  to  work  schemes  of  robbery  upon  the  investing  pub- 


ACQUISITION    OF   FIXED    CAPITAL  365 

lie.  No  reason  is  apparent  why  this  should  necessarily  be  so. 
The  honest  services  of  a  capable  promoter  are  indispensable 
to  the  flotation  of  every  comprehensive  and  far-reaching 
scheme  of  development  in  the  railroad  world,  or  elsewhere.  A 
clear  vision  to  see  opportunities,  ability  to  demonstrate  them  to 
others,  and  energy  to  push  to  completion  works  untried  but  of 
great  moment,  are  indispensable  to  material  development  and 
should  be  fairly  and  even  liberally  rewarded  by  the  public 
which  receives  the  benefit  of  those  works.  Such  rewards, 
however,  should  be  put  upon  a  clear  basis  of  business  princi- 
ple, should  be  of  sufficient  magnitude  to  encourage  rather  than 
discourage  enterprise,  and  should  not  be  so  great  as  to  make 
an  exorbitant  demand  which  is  perpetual  in  its  nature  upon 
the  community  to  be  served.  They  are  to  be  treated  simply 
as  just  payments  for  services  performed  for  the  corporation, 
which  services  are  valuable  and  in  many  cases  even  indispensa- 
ble. Such  services  should  be  paid  for  upon  the  basis  of  what 
they  are  fairly  worth,  having  regard  to  all  the  circumstances 
of  the  case 

'Tt  must  be  acknowledged,  however,  that  there  is  no  rec- 
ognized scale  of  market  values  for  the  services  of  a  promoter. 
Something  should  and  must  be  allowed  therefor  if  new  enter- 
prises in  an  untried  field  are  to  be  encouraged  and  carried  on. 
With  no  precedents  to  guide  it,  without  the  aid  of  any  sugges- 
tions or  arguments  from  outside,  the  Commission  does  not 
think  it  wise  to  lay  down  at  this  time  any  hard  and  fast  rule 
to  be  observed  by  it  in  cases  of  this  character.  It  seems  proba- 
ble that  in  the  long  run  the  best  solution  of  the  matter  will  be 
found  in  allowing  a  percentage  upon  the  cost  of  the  enterprise, 
such  percentage,  varying  with  the  circumstances  of  the  cases 
presented,  to  be  sufficient  to  encourage  rather  than  discourage 
legitimate  work  of  this  character,  and  yet  not  excessive  or 
extravagant  in  any  particular."  ^ 

If  the  fees  to  promoters  are  paid  in  money,  the  actual 

'Rochester,  Corning,  Elmira  Tr.  Co.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  166  (177178). 


366 


CAPITALIZATION 


amount  of  payment  may  be  charged  to  capital  accounts;  if 
payment  is  made  in  securities,  then  the  par  vahie  of  the  securi- 
ties should  be  capitalized.  In  the  accounting  classification  the 
Public  Service  Commissions  provide  that  capital  may  be 
charged  with  "the  actual  cash  value  at  the  time  of  organization 
of  securities  paid  to  promoters."  There  seems  to  be  no  reason, 
however,  why  a  corporation  should  recognize  anything  else 
than  the  par  value  of  its  securities,  unless  part  of  the  issue 
consists  of  bonds  which  by  express  agreement  have  been 
issued  at  a  fixed  per  cent  of  par.  Stock  must  of  necessity  be 
assumed  to  have  been  issued  at  par.  After  all,  there  were 
some  meritorious  aspects  to  the  issue  of  founders'  shares,  so 
called,  to  the  promoters.  These  made  their  compensation 
proportionate  to  the  success  of  the  enterprise. 

The  commission  may  inquire  into  the  reasonableness  of  a 
contract  between  the  directors  and  promoters  for  compensa- 
tion, and  it  will  allow  only  such  an  amount  to  be  included  in 
the  capitalization  as  will  appear  reasonable,  considering  all  the 
facts  in  the  case.  In  allowing  an  applicant  company  to  issue 
$75,000  stock  to  promoters,  where  $100,000  had  been  asked 
for,  the  Commissioner  (of  California  Commission)  writing 
the  report  said: 

"I  believe  this  project  must  be  considered  on  its  particular 
merits,  as  it  does  not  come  under  the  ordinary  category  of 
public  utility  enterprises.  Here  is  an  endeavor  to  construct  a 
railroad  for  a  distance  of  43  miles  into  an  undeveloped  ter- 
ritory described  as  largely  a  desert  country  now  very  sparsely 
settled.  It  is  a  territory  that  does  not  yield  gently  to  the  hand 
of  man,  but  requires  pioneering,  exploring,  and  development 
with  unusual  hazards  and  risks.  There  must,  therefore,  be 
the  lure  of  unusual  profits.  I  feel,  also,  that  it  is  proper  to  take 
into  consideration  the  benefit  to  the  community  of  this  State 
as  a  whole  which  will  accrue  through  the  construction  of  this 
railroad.  It  is  trite  to  say  that  California  is  a  land  of  vast 
possibilities  awaiting  development.     Here  is  an  extreme  case 


ACQUISITION    OF   FIXED    CAPITAL  367 

in  point,  where  men  have  banded  together  to  open  up  a  whole 
section  of  this  state — a  principality  in  itself,  long  isolated 
and  forbidding  in  its  inaccessibility,  difficulties  and  hazards. 

"I  recommend  that  Mr.  Neeland  and  his  associates  be  al- 
lowed $75,000  par  value  of  this  stock,  and  this  stock  should 
be  issued  when  the  projectors  have  brought  their  enterprise  to  a 
successful  conclusion  by  the  completion  of  their  track  for  the 
entire  distance  contemplated."  ^ 

§  181.     (2)  Franchises 

The  franchises  of  a  corporation  are  the  privileges  vested 
in  and  to  be  exercised  by  it,  representing  mainly  rights  to 
occupy  streets,  highways,  and  public  places  with  railroad  tracks, 
pipe  lines,  pole  lines,  etc.  The  franchises  of  a  corporation  do 
not  include  the  right  to  be  a  corporation,  which  is  a  privilege 
conferred  upon  the  incorporators  and  not  upon  the  corporation. 
Quoting  the  New  York  Court  of  Appeals: 

"The  charter  of  a  corporation  is  the  law  which  gives  it 
existence  as  such.  That  is  its  general  franchise,  which  can 
be  repealed  at  the  will  of  the  legislature.  A  special  franchise  is 
the  right,  granted  by  the  public,  to  use  public  property  for  a 
public  use,  but  with  private  profit,  such  as  the  right  to  build  and 
operate  a  railroad  in  the  streets  of  a  city.  Such  a  franchise, 
when  acted  upon,  becomes  property  and  cannot  be  repealed,  un- 
less power  to  do  so  is  reserved  in  the  grant,  although  it  may  be 
condemned  upon  making  compensation.  As  we  recently  said:  ^ 
'The  general  franchise  of  a  corporation  is  its  right  to  live  and 
to  do  business  by  the  exercise  of  the  corporate  powers  granted 
by  the  state.  The  general  franchise  of  a  street  railroad  com- 
pany, for  instance,  is  the  special  privilege  conferred  by  the 
state  upon  a  certain  number  of  persons  known  as  the  corpora- 
tors to  become  a  street  railroad  corporation,  and  to  construct 
and  operate  a  street  railroad  upon  certain  conditions.     Such  a 


"In  re  California  Southern  R.  R.  Co.,  P.  U.  R.  1915-F.  3"   (318). 

3  People  ex  rel.  Metropolitan  Street  Ry.  Co.  v.  State  Tax  Com.,  174  N.  Y.  417  (43s)- 


368  CAPITALIZATION 

franchise,  however,  gives  the  corporation  no  right  to  do  any- 
thing in  the  public  highways  without  special  authority  from 
the  state,  or  some  municipal  officer  or  body  acting  under  its 
authority.  When  a  right  of  way  over  a  public  street  is 
granted  to  such  a  corporation,  with  leave  to  construct  and 
operate  a  street  railroad  thereon,  the  privilege  is  known  as 
a  special  franchise,  or  the  right  to  do  something  in  the  public 
highway,  which,  except  for  the  grant,  would  be  a  trespass.' 

"The  right  to  be  a  corporation  is  frequently  called  a  fran- 
chise, as  it  is  in  one  sense,  but  not  in  the  sense  that  the  grant 
of  a  right  to  build  a  railroad  in  a  public  street  is  a  franchise, 
and  it  is  unfortunate  that  the  same  word  is  used  with  widely 
different  meanings,  for  it  leads  to  confusion  unless  qualified 
by  an  appropriate  adjective,  such  as  'general'  or  'special.' 
The  right  to  be  a  corporation,  or  the  corporate  right  of  life,  is 
inseparable  from  the  corporation  itself.  It  is  part  of  it  and 
cannot  be  sold  or  assigned.  That  franchise  is  general  and 
dies  with  the  corporation,  for  it  cannot  survive  dissolution  or 
repeal.  On  the  other  hand,  grants  to  do  something  in  the  pub- 
lic streets,  or  special  franchises  are  not  a  part  of  the  corpora- 
tion. They  can  be  made  to  an  individual  with  the  same  legal 
force  or  effect  as  to  a  corporation.  Unless  there  is  some  legis- 
lative restriction,  they  can  be  mortgaged  and  sold.  They  are 
no  part  of  the  corporate  life,  if  owned  by  a  corporation,  any 
more  than  they  are  a  part  of  the  individual  life  if  owned  by  a 
human  being."  * 

Cost  of  Acquiring  Grant.  The  capitalization  of  franchises 
has  occupied  a  large  place  in  the  general  abuse  to  which  the 
capitalization  of  intangibles  has  been* subjected ;  they  have  been 
taken  into  the  capital  accounts  at  high  values  against  which  to 
issue  stocks  and  bonds.  There  can  be  no  doubt  that  if  a  cor- 
poration has  been  required  to  pay  for  a  franchise  or  has  been 
subjected  to  any  cost  in  acquiring  it,  it  will  be  wholly  proper 
to  charge  such  costs  to  the  capital  accounts.  It  is  worth  while 

*  Lord  V.  Equitable  Life  Assn.,  194  N.  Y.  212  (226). 


ACQUISITION    OF   FIXED    CAPITAL  269 

to  note  in  passing  that  the  usual  method  of  selHng  franchises 
is  an  illogical  and  short-sighted  expedient,  to  be  justified  only 
upon  the  theory  of  indirect  taxation,  for  those  who  are  sup- 
posed to  receive  the  benefit  of  the  purchase  price  are  the  same 
persons  who  always  thereafter  will  be  required  to  pay  a  rate 
for  service  which  will  include  a  fair  return  on  the  purchase 
price  paid  by  the  corporation. 

Legislation  has  been  necessary  to  discontinue  the  practice 
of  issuing  securities  against  inflated  values  placed  upon  fran- 
chises. The  Public  Service  Commissions  Law  of  New  York 
provides  that  ''the  commission  shall  have  no  power  to  author- 
ize the  capitalization  of  any  franchise  or  the  right  to  own, 
operate  or  enjoy  any  franchise  whatsoever  in  excess  of  the 
amount  (exclusive  of  any  tax  or  annual  charge)  actually  paid 
to  the  state  or  to  a  political  subdivision  thereof  as  the  consid- 
eration for  the  grant  of  such  franchise  or  right." 

Conditions  of  Grant  Involving  Annual  Expense.  In  grant- 
ing franchises  municipalities  have  often  imposed,  in  addition 
or  in  heu  of  a  present  consideration,  various  requirements 
which  subject  the  corporation  to  annual  expense  on  account 
of  the  franchise.  They  have  demanded,  for  instance,  a  pro- 
portion of  the  gross  earnings,  or  the  rendition  of  a  certain 
amount  of  free  service,  such  as  free  lighting  of  municipal 
buildings.  Of  course,  this  means  that  the  users  of  the  service 
must  pay  just  so  much  more  to  compensate  the  utility  for  the 
cost  of  the  free  service  rendered  or  the  percentage  of  revenue 
turned  over.  In  every  case  the  utility  is  entitled  to  demand 
rates  which  will  permit  an  adequate  return  upon  the  property 
after  the  deduction  of  these  costs  and  payments.  Public  Serv- 
ice Commissions  almost  uniformly  have  condemned  such 
reservations  on  the  part  of  municipalities,  :md  have  considered 
the  rendition  of  free  service  as  clearly  discriminatory,  while 
the  New  Jersey  Supreme  Court  has  held  that  the  provisions  of 
the  public  utility  law  prohibiting  discriminatory  contracts  apply 
with  full  force  and  effect  to  contracts  with  municipalities. 


370  CAPITALIZATION 

Corporations  have  sometimes  attempted  to  capitalize  the 
future  expense  of  franchise  obhgations,  i.e.,  to  issue  securities 
against  the  present  worth  of  the  sums  required  to  be  paid  peri- 
odically during  the  life  of  the  franchise,  or  of  the  value  of  the 
services  to  be  rendered.  In  an  application  before  the  Public 
Service  Commission,  Second  District,  it  was  proposed  thus  to 
capitalize  the  franchise  obligations  of  an  electric  company 
which  was  required  to  furnish  free  current.  The  value  of  the 
current  delivered  free  under  the  franchise  provisions  had  been 
amounting  to  about  $4,000  each  year,  and  on  that  basis  the 
total  expenditure  for  the  balance  of  the  term  of  the  franchise 
was  estimated  at  about  $188,000,  for  which  amount  securities 
were  sought  to  be  issued.  Authorization  was  refused,  the 
Commission  holding  that  no  other  course  was  open  to  it  in 
view  of  the  prohibition  of  the  statute  against  the  capitalization 
of  any  franchise  "in  excess  of  the  amount  (exclusive  of  any 
taxor  annual  charge)  actually  paid  ....  as  the  consideration 
for  the  grant  of  such  franchise."  The  Commission  holds  that: 
"The  only  possible  meaning  to  attach  to  the  language  'exclusive 
of  any  tax  or  other  annual  charge'  is  that  the  annual  charge 
cannot  be  capitalized."  It  explains  the  general  proposition  as 
follows: 

"If  a  corporation  pays  a  municipality  a  fixed  sum  for  a 
franchise  at  the  time  it  is  granted,  it  is  clear  that  the  sum.  so 
paid  may  be  capitalized  by  the  issue  of  stock  to  that  amount. 
The  question  has  been  raised,  why  a  deferred  payment  may  not 
also  be  capitalized.  That  is  to  say,  if  instead  of  paying  a  fixed 
sum  at  the  outset  the  corporation  is  required  to  pay  in  cash  or 
service  a  certain  amount  each  year  during  the  continuance  of 
the  franchise,  why  may  not  stock  to  the  same  amount  be  is- 
sued to  represent  such  payment  ?  .  .  .  . 

"Stock  issued  to  a  person  is  an  evidence  that  he  has  ad- 
vanced money,  property,  or  services  to  the  corporation  upon 
which  he  is  entitled  to  a  return  by  way  of  dividends  earned  and 
to  a  part  of  the  assets  of  the  corporation  in  case  of  its  disso- 


ACQUISITION    OF   FIXED    CAPITAL  371 

lution.  When  the  corporation  pays  a  fixed  sum  as  considera- 
tion for  a  franchise  it  must  derive  the  money  either  from  sur- 
pkis  or  someone  must  advance  it  to  the  corporation.  In  the 
latter  case,  either  stock  or  bonds  may  be  issued  to  the  person 
advancing  the  money If  the  money  be  paid  from  sur- 
plus, obviously  neither  stock  nor  bonds  can  be  issued  since  no 
one  other  than  the  corporation  is  entitled  to  them.  The  cor- 
poration by  making  the  payment  with  its  surplus  merely 
changes  the  form  of  the  surplus  from  cash  to  franchises 

"In  case  of  a  deferred  payment,  for  cash  or  service,  no 
person  at  the  time  the  franchise  is  granted  makes  any  advance 
either  to  the  municipality  or  to  the  corporation  of  money,  prop- 
erty, or  services,  and  hence  no  person  is  entitled  to  either  stock 
or  bonds 

"The  underlying  principle  is  that  w^hatever  a  municipality 
receives  from  a  corporation  for  a  franchise  may  be  added  to 
the  charge  for  service.  If  the  payment  is  made  annually  in 
either  money  or  service,  the  corporation  may  recoup  itself  di- 
rectly from  its  customers  in  that  year.  If  the  payment  is  made 
in  a  lump  sum  at  thetime  of  granting  the  franchise,  the  amount 
paid  must  be  spread  over  all  the  bills  for  the  entire  term  of  the 
franchise.  This  can  only  be  done  by  issuing  stock  or  bonds  to 
the  persons  advancing  the  money  paid  and  making  annual  re- 
turn to  them  by  way  of  dividend  or  interest.  Such  dividend 
or  interest  is  spread  over  the  annual  bills,  and  in  this  way  the 
customers  of  the  company  pay  just  what  they  ought  to  pay  and 
no  more."  ^ 

Costs  of  Procuring  Assignment  of  Franchises.  Where  a 
franchise  is  acquired  through  purchase  or  assignment,  the  full 
amount  paid  for  its  acc|uisition  can  be  capitalized.  The  transfer 
of  a  franchise  is  now  subject  to  the  authorization  of  the  Com- 
mission, which  will  inquire  into  the  consideration  to  be  paid 
and  the  manner  of  payment,  so  that  the  danger  of  overcapital- 
ization is  slight.    As  a  matter  of  fact,  in  the  initial  development 

^  Genesee  Light  and  Power  Co.,  2  P.  S.  C.  Rep.   (2nd  D.,  N.  Y.)  48J. 


372 


CAPITALIZATION 


of  a  corporation  few  franchises  are  acquired  directly;  most  of 
tliem  being  granted  to  the  incorporators  who  later  turn  them 
over  to  the  corporation.  It  goes  without  saying  that  where  a 
franchise  is  acquired  by  an  individual  on  behalf  of  a  corpora- 
tion about  to  be  formed,  the  charge  to  the  corporation  should 
be  no  greater  than  the  actual  cost  to  the  immediate  grantee. 

Accounting  Requirements.  The  text  of  the  fixed  capital 
account  "Franchises"  in  the  Uniform  Systems  of  Accounts  of 
New  York  is  as  follows: 

"To  this  account  shall  be  charged  'the  amount  (exclusive 
of  any  tax  or  annual  charge)  actually  paid  to  the  State  or  to  a 
political  subdivision  thereof  as  the  consideration  for  the  grant 
of  such  franchise  or  right '  (Section  69  of  Public  Service  Com- 
missions Law)  as  is  necessary  to  the  conduct  of  the  corpora- 
tion's electric  operations.  If  any  such  franchise  is  acquired 
by  mesne  assignment,  the  charge  to  this  account  in  respect 
thereof  must  not  exceed  the  amount  actually  paid  therefor  by 
the  corporation  to  its  assignor,  nor  shall  it  exceed  the  amount 
specified  in  the  statute  above  quoted.  Any  excess  of  the  amount 
actually  paid  by  the  corporation  over  the  amount  specified  in 
the  statute  shall  be  charged  to  the  account  'Other  Intangible 
Electric  Capital.'  If  any  such  franchise  has  a  life  of  not  more 
than  one  year  after  the  date  zvhen  it  is  placed  in  service,  -it 
shall  not  be  charged  to  this  account  but  to  the  appropriate  ac- 
counts in  'Operating  Expenses,'  and  in  'Prepayments'  if  ex- 
tending beyond  the  fiscal  year. 

"Payments  made  to  the  state  or  to  some  political  subdi- 
vision thereof  as  a  consideration  for  granting  an  extension  for 
more  than  one  year  of  the  life  period  of  a  franchise  shall  be 
classed  as  renewals.  Those  made  as  a  consideration  for  fran- 
chises or  extensions  thereof  covering  additional  territory  to  be 
operated  as  a  part  of  an  existing  system  shall  be  classed  as 
betterments.  If  the  franchises  cover  separate  and  distinct  new 
enterprises,  the  payments  therefor  shall  be  classed  as  original. 

"Note. — Annual  or  more  frequent  payment  in  respect  of 


ACQUISITION    OF   FIXED    CAPITAL 


373 


franchises  must  not  be  charged  to  this  account  but  to  the  ap- 
propriate tax  or  operating  expense  account." 

In  respect  to  the  matters  referred  to  in  the  note,  there  is 
included  in  the  operating  expenses  an  account  entitled  "Fran- 
chise Requirements,"  which,  for  electrical  corporations,  reads 
as  follows: 

"Charge  to  this  account  the  cost  of  all  energy  and  materials 
and  supplies  furnished  to  municipal  corporations  in  compliance 
with  franchise  requirements  and  for  which  no  payment  is  re- 
ceived by  the  corporation;  also  of  all  direct  expense,  such  as 
paving  and  other  like  matters,  incurred  in  compliance  with 
such  requirements  and  for  which  no  reimbursement  is  received 
by  the  corporation.  Amounts  charged  to  this  account  for 
which  there  is  no  direct  money  outlay  shall  be  credited  to  the 
below  provided  account  'Duplicate  Electric  Charges — Credit.'  " 

This  account  is  introduced  into  operating  expenses  to  obvi- 
ate a  credit  to  revenue  for  the  assumed  value  of  the  services 
rendered. 

Where  franchise  rights  may  not  be  exercised  without  the 
prior  authorization  of  a  state  commission,  an  interesting  situ- 
ation arises  where  a  corporation  secures  a  franchise  for  a 
valuable  consideration,  say,  payment  of  $2,000.  It  may  capi- 
talize that  sum  if  the  franchise  is  ratified  by  the  commission, 
but  would  it  be  proper  so  to  capitalize  it  if  the  commission  re- 
fuses to  sanction  the  exercise  of  powers  thereunder?  There 
will  then  be  no  operations  to  which  the  annual  return  upon 
that  payment  may  be  charged,  and  it  will  not  be  fair  to  assess 
against  the  customers  in  one  municipality  the  annual  burden  of 
an  alleged  capital  expenditure  which  actually  accrued  to  the 
benefit  of  another  municipality.  Manifestly,  the  payment  can- 
not be  capitalized  under  these  circumstances  but  must  be  writ- 
ten off  through  the  surplus  account  as  a  loss  to  the  stockholders. 
As  a  matter  of  fact,  the  corporation  will  protect  itself  through 
an  agreement  that  it  will  be  relieved  from  the  obligation  to 
take  the  franchise  if  it  is  not  ratified. 


274  CAPITALIZATION 

§  182.     (3)  Patent  Rights 

The  capitaHzation  of  patent  rights  is  not  of  very  much  im- 
portance in  the  pubHc  utihties  field,  since  patents  for  new  appH- 
ances  or  processes  are  usually  acquired  by  manufacturing 
corporations.  If  patent  rights  are  obtained  by  a  public  utility 
pertaining  to  appliances  or  processes  to  be  used  in  its  own 
operations,  the  amount  paid  for  the  patent  may  be  charged 
against  its  fixed  capital  accounts  and  securities  issued  against 
it;  or  if  the  patented  article  has  been  originated  through  the 
research  department  and  by  the  employees  of  the  corporation 
itself,  all  of  the  expenses  of  developing  the  idea,  and  the  fees 
and  other  expenses  incurred  in  securing  the  patent,  could  be 
so  charged. 

The  text  of  the  account  "Patent  Rights"  as  contained  in  the 
Uniform  Systems  of  Accounts  of  New  York  is  as  follows: 

"Charge  to  this  account  the  cost  of  all  rights  (having  a 
life  of  more  than  one  year  from  the  date  when  placed  in  ser- 
vice) acquired  by  the  corporation  in  or  under  valid  patents 
granted  by  the  United  States  to  inventors  for  inventions  and 
discoveries  which  are  necessary  to  the  economical  conduct  of 
the  corporation's  street  railroad  operations.  If  any  such  rights 
are  extended  to  cover  a  further  period  of  time  than  that  cov- 
ered by  the  original  grant,  the  cost  of  such  extension  shall  be 
classed  as  a  renewal.  A  patent  right  acquired  for  use  in  an 
existing  system  and  necessary  to  the  economical  operation 
thereof  shall  be  classed  as  an  addition." 

§  183.     (4)   Contract  Rights 

The  capitalization  of  the  assumed  value  of  a  contract  giving 
to  the  corporation  some  specific  right  or  claim  through  which 
revenue  accrues  to  it,  or  which  confers  some  benefit  upon  the 
corporation,  has  been  quite  usual.  It  has  been  so  often  used  as 
a  device  for  fictitious  capitalization,  however,  that  the  practice 
has  fallen  under  condemnation  and  such  an  item  in  the  fixed 
capital  accounts  will  be  scrutinized  very  carefully  before  its 


ACQUISITION    OF    FIXED    CAPITAL  375 

propriety  will  be  admitted.  Under  exceptional  circumstances, 
where  a  valuable  contract  is  secured,  promising  a  clear  and 
substantial  benefit  to  the  owner  so  that  it  may  be  reasonably 
considered  to  constitute  a  valuable  asset,  the  cost  of  its  acqui- 
sition, e.g.,  the  purchase  price  if  a  payment  was  made  for  its 
acquisition,  or  fees  and  commissions  paid  in  the  course  of 
negotiation  and  acquisition,  may  be  charged  to  capital  accounts 
and  securities  issued  against  it.  But  the  amounts  so  charged 
should  be  amortized  during  the  life  of  the  contract  and  out  of 
the  earnings  accruing  from  its  use.     (See  §  184.) 

The  Public  Service  Commissions  Law  of  New  York  pro- 
vides: "Nor  shall  any  contract  for  consolidation  or  lease  be 
capitalized  in  the  stock  of  any  corporation  whatever;  nor  shall 
any  corporation  issue  any  bonds  against  or  as  a  lien  upon  any 
contract  of  consolidation  or  merger."  The  prohibition  relates 
to  a  class  of  contracts  the  capitalization  of  which  was  fre- 
quently resorted  to  for  the  purpose  of  introducing  water  into 
the  capitalization,  and  which  was  wholly  unsupported  by  any 
excuse  or  warrant  for  its  inclusion  in  capital  accounts.  Con- 
cerning other  kinds  of  contracts  there  is  no  specific  provision 
in  the  law,  neither  has  any  rule  governing  the  matter  been 
carried  into  the  accounting  classifications. 

In  Fuhrmann  v.  Cataract  Power  Co.,^  a  rate  case,  the  com- 
pany sought  to  include  in  the  value  of  its  fixed  capital 
$2,000,000  as  the  value  of  certain  contracts  with  the  Niagara 
Falls  Power  Company  under  which  it  was  privileged  to  pur- 
chase from  the  latter  "for  over  a  thousand  years  at  least 
37,500  horse-power  at  the  rate  of  $16  per  horse-power  per 
annum."  The  company's  contention  as  to  the  value  of  the 
contract  and  the  propriety  of  capitalizing  that  value  were 
stated  as  follows  in  the  brief  of  its  counsel: 

"With  the  evidence  undisputed  in  the  record  that  there  is 
a  demand  on  the  part  of  the  consumers  at  Niagara  Falls  for 
power  at  $20  per  horse-power  per  annum;  that  the  cost  of 

«  3  p.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  656. 


376 


CAPITALIZATION 


transmitting  power  to  the  Biififalo  city  line  is  approximately 
$4  per  horse-power  per  annum,  making  a  total  cost  here  of  $24 
per  horse-power  per  annum,  assuming  that  there  were  any 
Falls  power  available,  which  is  not  the  fact;  with  the  un- 
disputed testimony  in  the  record  that  the  cost  of  generating 
electric  power  in  Buffalo  with  the  most  modern  steam  plant 
would  range  from  $25  to  $28  per  horse-power  per  annum,  can 
it  reasonably  be  questioned  that  this  contract,  requiring  the 
delivery  of  37,500  horse-power  at  the  city  line  every  year 
during  the  term  of  the  Cataract's  franchise  (nineteen  years 
yet  to  run)  and  beyond  for  upward  of  a  thousand  years  at 
the  rate  of  $16  per  horse-power  has  a  value?  Clearly  not. 
How  then  should  such  value  be  arrived  at  ? 

"Assuming  the  market  value  of  hydro-electric  power  at 
the  Falls  at  $20  per  horse-power  per  annum,  and  assuming  $4 
per  horse-power  per  annum  as  the  cost  of  transmission  to  the 
Buffalo  city  line,  we  have  $24  per  horse-power  per  annum  as 
the  market  value  of  Falls  power  at  the  Buffalo  city  line, 
assuming  there  were  any  available. 

"Applying  the  other  test  as  to  the  cost  of  generating  elec- 
tric power  by  a  modern  steam  plant  in  Buffalo,  we  have  $25 
to  $28  per  horse-power  as  the  lowest  estimate  for  the  cost  of 
steam  generation.  It  is  apparent,  therefore,  that  the  only 
logical  way  of  arriving  at  the  value  of  this  contract  is  by  tak- 
ing the  difference  between  the  cost  of  power  under  the  contract 
and  the  cost  of  power  generated  here  by  steam.  The  difference 
is  $9  per  horse-power  per  annum.  Multiply  this  by  the  37,500 
horse-power  which  the  power  company  is  required  to  deliver 
us,  and  we  get  the  annual  saving  of  $337,500  per  annum.  This 
sum  capitalized  at  8  per  cent  would  be  over  $4,000,000." 

In  contending  for  a  valuation  of  $2,000,000  instead  of 
$4,000,000  the  company  claimed  to  be  dividing  with  the  public 
the  benefits  of  the  conceded  fact  that  Niagara-generated  power 
was  cheaper  than  steam-generated  power.  In  the  words  of 
the  principal  witness  for  the  company:     "My  conclusion  is 


ACQUISITION    OF   FIXED    CAPITAL  377 

that  it  is  fair  to  all  parties  to  divide  the  advantages  of  hy- 
draulic generated  electric  power  between  the  public  and  the 
people  whose  enterprise  makes  the  utihty  of  the  hydraulic 
power  by  this  process." 

The  Commission  refused  to  allow  any  valuation  whatever 
for  the  contract  on  the  ground  that  the  value  of  the  contract 
depended  upon  the  price  which  the  company  would  be  per- 
mitted to  collect  for  its  service;  if  the  price  of  $25  per  horse- 
power on  which  it  based  the  profit  of  $9  per  horse-power  were 
reduced,  the  supposed  value  of  the  contract  would  be  cor- 
respondingly decreased. 

"No  generating  company  using  the  water  of  Niagara  river 
owns  those  waters  or  has  any  right  or  title  to  them  whatsoever. 
By  the  permission  of  the  Federal  Government  and  of  the  State 
of  New  York,  the  generating  companies  operating  at  the  Falls 
are  given  the  free  use  of  those  waters  in  the  production  of 
electric  energy.  To  say  that  by  having  been  given  the  free 
use  of  those  waters  for  that  purpose  they  are  vested  with  an 
unassailable  right  to  charge  as  much  for  the  electric  energy 
developed  as  they  would  for  energy  developed  by  steam  plant, 
is  a  proposition  which  requires  to  be  maintained  rather  than 
to  be  refuted.  It  may  very  well  be  that  these  companies  are 
entitled,  in  view  of  all  of  the  circumstances  of  the  case,  to  a 
liberal  return  upon  the  capital  actually  invested  in  developing 
the  energy.  It  may  very  well  be  that  the  people  exploiting  the 
enterprise  are  entitled  to  large,  and  even  very  large,  profits  for 
the  skill  they  have  displayed  and  the  risk  to  wkich  they  have 
subjected  their  capital.  It  may  be  that  the  public  ought  to  pay 
them  very  liberally  for  the  work  which  they  have  carried  on 
in  the  public  interest ;  but  to  say  that  the  public  is  entitled  to  no 
advantage  from  the  use  of  these  waters,  that  the  territory  which 
can  be  served  with  electric  energy  developed  at  Niagara  Falls 
has  no  advantage  and  is  entitled  to  no  benefit  by  reason  of 
proximity  to  those  Falls,  is  to  say  something  which  does  not 
appeal  to  the  best  judgment  of  mankind  for  an  instant. 


278  CAPITALIZATION 

"We  may  therefore  dismiss  without  further  consideration 
the  claim  of  the  company  that  its  contract  with  the  Niagara 
Falls  Power  Company  has  a  value  of  $2,000,000  upon  which 
it  is  entitled  as  a  matter  of  right  to  a  return  of  not  less  than 
6  per  cent  per  annum;  and  the  question  of  what  return  it  is 
entitled  to,  if  any,  in  excess  of  the  cost  of  steam  generated 
electric  energy,  is  one  which  may  be  considered  in  another 
connection." 

§  184.     (5)  Other  Intangible  Capital 

The  text  of  the  account  "Other  Intangible  Capital"  in  the 
Uniform  System  of  Accounts  for  Street  Railroad  Corpora- 
tions, New  York,  is  as  follows: 

"Charge  to  this  account  the  cost  of  all  other  property  com- 
ing within  the  definition  of  intangible  capital  and  devoted  to 
street  railroad  operations.  All  entries  of  charges  to  this  ac- 
count shall  describe  the  acquired  property  with  sufficient  par- 
ticularity clearly  to  identify  it,  and  shall  also  show  specifically 
the  principal  from  whom  acquired  and  all  agents  representing 
such  principal  in  the  transaction;  also  the  term  of  life  of  such 
property,  estimated  if  not  known,  and  if  estimated,  the  facts 
upon  which  the  estimate  is  based." 

This  account  has  often  been  used,  and  is  intended  to  be 
used,  in  a  manner  approaching  the  use  of  the  account  "Good- 
will" in  ordinary  private  enterprises.  It  has  been  definitely 
established  that  "Good-will,"  as  the  term  is  understood,  can- 
not exist  in  the  case  of  public  utilities  which  represent,  in  the 
main,  natural  monopolies.  It  has  been  the  accounting  practice, 
however,  in  relation  to  other  classes  of  corporations  to  charge 
to  a  "Good-will"  account  the  excess  of  consideration  paid  for 
a  plant  or  a  going  business  acquired  by  the  accounting  corpora- 
tion over  the  actual  value  of  the  physical  assets  coming  into 
its  possession.  A  like  function  is  performed  by  this  account 
"Other  Intangible  Capital,"  as  explained  hereinafter  under  the 
heading  "Purchase  of  Plant,"  §  187. 


ACQUISITION    OF    FIXED    CAPITAL  37CJ 

§  185.  Capitalization  for  Acquisition  of  Tangible  Capital — 
(i)  Construction 

The  greater  part  of  the  capitalization  of  public  utility  cor- 
porations represents  expenditures  for  "structures  and  equip- 
ment having  an  expectation  of  life  in  service  of  more  than  one 
year,"  i.e.,  for  the  acquisition  of  tangible  capital,  and  in  by  far 
the  greater  number  of  instances  these  expenditures  are  those 
made  by  the  corporation  itself  for  construction  of  its  own  plant 
rather  than  the  purchase  thereof  from  others. 

In  considering  an  application  for  authorization  to  issue 
stocks  and  bonds  the  proceeds  of  which  are  to  be  used  for  con- 
struction, the  determination  of  the  amount  to  be  allowed  by 
the  commission  will  resolve  itself  into  the  determination  of 
what  the  construction  will  cost.  Whether  the  plant  shall  be 
built  or  not,  that  is,  the  question  of  the  company's  entrance  into 
that  particular  territory,  will  already  have  been  determined. 

The  probable  cost  of  construction  is  an  estimate,  of  course, 
and  only  approximate,  unless  it  is  proposed  to  have  the  work 
performed  by  contractors  under  an  agreement  so  definite  in 
its  terms  that  the  cost  to  the  public  utility  corporation  will  be 
fixed  beyond  the  possibility  of  any  change.  Usually  the  actual 
cost  will  be  more  or  less  than  the  estimate,  either  through 
changes  in  the  character  of  the  originally  proposed  construc- 
tion, or  through  fluctuations  in  the  prices  of  materials  and  the 
wages  of  labor  during  the  construction  period,  or  else  through 
unforeseen  accidents  which  delay  the  work  and  thus  increase 
the  overhead  expenses.  The  considerations  necessitated  by 
these  circumstances  are  thus  stated  by  the  Public  Service  Com- 
mission for  the  Second  District  of  New  York: 

"It  follows  ....  that  an  order  establishing  the  capitali- 
zation of  a  new  enterprise  should  be  sufficiently  flexible  to 
allow  of  additional  capitalization  if  properly  required  to  com- 
plete the  work.  It  also  follows  that  if  the  spirit  of  the  law 
is  to  be  observed,  any  such  order  should  so  hedge  about  the 
issue  of  stock  and  bonds  with  just  and  reasonable  restrictions 


38o 


CAPITALIZATION 


that  it  will  be  practically  impossible  for  a  company  to  secure 
more  capitalization  than  is  actually  necessary  for  the  purposes 
contemplated  by  the  Commission  in  granting  the  authorization, 
and  that  if  the  original  estimate  and  allowance  are  too  great 
the  actual  issue  may  be  restricted  to  such  sums  as  are  necessary 
and  at  the  same  time  ensure  the  completion  of  the  work  ac- 
cording to  the  plans  and  specifications  submitted  by  the  ap- 
plicant to  the  Commission."  ^ 

Proper  restrictions  upon  the  issue  of  stocks  and  bonds 
authorized  for  construction  purposes  are  not  difficult  to  devise 
or  to  adapt  to  particular  cases.  They  should  be  such  that, 
coupled  with  the  commission's  control  over  the  accounts  and 
its  power  to  inspect  the  plant  and  equipment,  the  danger  of 
manipulation  of  estimates  and  costs  may  be  obviated;  such, 
for  instance,  as  an  attempt  to  cheapen  or  restrict  the  con- 
struction first  proposed  so  as  to  leave  a  balance  of  unexpended 
proceeds  of  the  authorized  issues  to  be  devoted  to  purposes 
other  than  those  contemplated  in  the  authorization. 

All  the  comments  made  in  foregoing  pages  concerning  the 
detail  to  be  observed  in  fixed  capital  accounting,  the  basis  upon 
which  entries  should  be  made,  etc.,  apply  most  directly  to  the 
record  of  construction  expenditures.  It  should  be  possible 
from  these  accounts  to  tell  not  only  the  actual  and  complete 
cost  of  the  plant  as  a  whole  but  also  of  each  separate  facility. 
A  glance  at  the  list  of  accounts  enumerated  in  the  Uniform 
Systems  of  Accounts  will  indicate  the  separation  of  expendi- 
tures to  be  recorded  upon  the  books.  Taking,  for  example,  the 
extended  ^  classification  for  electric  railroad  corporations, 
there  will  be  found  five  groups  of  accounts:  "Roadway," 
"Electric  Line,"  "Buildings  and  Structures,"  "Power  Plant 


■'Rochester,  Corning,  Elmira  Traction  Co.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.Y.)  166  (179). 

*  The  New  York  Public  Service  Commissions  have  classified  the  corporations  sub- 
ject to  their  jurisdictions  and  have  issued  separate  accounting  systems  for  the  different 
classes.  Electric  railroad  corporations  with  annual  gross  operating  revenues  above 
$500,000  have  received  the  extended  accounting  order;  those  with  annual  revenues  of 
less  than  $500,000  and  over  $100,000  have  received  a  condensed  classification,  and  those 
with  revenues  of  less  than  $ico,ooo  have  received  one  still  further  condensed.  Electrical 
and  gas  corporations  are  similarly  classified,  but  a  classification  still  further  condensed  is 
provided  for  those  with  revenues  of  less  than  $25,000. 


ACQUISITION    OF   FIXED    CAPITAL  381 

Equipment,"  "Rolling  Stock  and  Miscellaneous  Equipment." 
In  the  first  group,  "Roadway,"  there  are  fifteen  accounts — 
Grading,  Ballast,  Ties,  Rails,  Special  Work,  Underground 
Construction,  Track  Laying  and  Surfacing,  Paving,  Roadway 
Tools,  Tunnels,  Elevated  Structures,  Bridges  and  Trestles, 
Crossings  and  Signs,  Interlocking  and  Other  Signal  Appar- 
atus, Telephone  and  Telegraph  Lines.  These  accounts  must 
be  kept  separately.  Under  the  second  group  of  "Electric  Line" 
there  are  four  accounts  to  show  separately  the  cost  of  poles  and 
fixtures,  underground  conduits,  transmission  system,  and  dis- 
tribution system.  Under  the  third  group,  "Buildings  and 
Structures,"  there  are  eight  accounts  for  the  expenditures  on: 
Dams,  Canals,  and  Pipe  Lines,  Power  Plant  Buildings,  Sub- 
station Buildings,  General  Ofiice  Buildings,  Shops  and  Car 
Houses,  Stations,  Docks  and  Wharves,  Park  and  Resort  Prop- 
erties. There  are  eight  accounts  in  the  group  "Power  Plant 
Equipment,"  and  six  in  the  group  "Rolling  Stock  and  Mis- 
cellaneous Equipment." 

The  cost  to  be  recorded  in  each  account  should  be  the 
complete  cost,  including,  in  addition  to  the  labor  and  material 
directly  applicable,  such  proportions  of  other  general  and  over- 
head expenses  as  may  be  properly  assignable  to  that  account. 
These  general  and  overhead  expenses  very  often  are  difficult  of 
apportionment,  however,  and  for  that  reason  separate  accounts 
are  provided  wherein  unapportioned  expenditures  may  be  re- 
corded. The  text  of  these  accounts  in  the  Uniform  Systems  of 
Accounts  of  New  York  indicates  their  nature  very  clearly. 

"Engineering  and  Superintendence.  Charge  to  this  ac- 
count all  expenditures  for  services  of  engineers,  draughtsmen, 
and  superintendents  employed  on  preliminary  and  construc- 
tion work,  and  all  expenses  incident  to  the  work  when  such 
disbursements  cannot  be  assigned  to  specific  construction. 

"Note.  When  employees  enumerated  above  are  engaged  in 
work  not  chargeable  to  construction,  their  pay  and  expenses 
shall  be  charged  to  the  specific  work  on  w-hich  engaged. 


382 


CAPITALIZATION 


"Law  Expenditures  During  Construction.  Charge  to  this 
account  general  expenditures  of  the  following  nature,  incurred 
in  connection  with  the  construction  of  a  road,  namely:  the 
pay  and  expenses  of  all  counsel,  soHcitors,  and  attorneys,  their 
clerks  and  attendants,  and  expenses  of  -their  offices;  printing 
briefs,  legal  forms,  testimony,  reports,  etc. ;  payments  to  arbi- 
trators for  the  settlement  of  disputed  questions,  costs  of  suit 
and  payment  of  special  fees,  notarial  fees,  and  witness  fees; 
and  expenses  connected  with  taking  depositions ;  also  all  legal 
and  court  expenses. 

"When  any  of  the  expenditures  above  enumerated  can  be 
charged  directly  to  the  account  for  which  incurred,  they  shall 
be  so  charged  and  not  to  this  account.  Expenditures  in  con- 
nection with  the  acquisition  of  the  right  of  way  or  other  land 
shall  be  charged  to  account  'Right  of  Way,'  or  account 
'Othei-  Street  Railroad  Land,'  according  to  the  character  of 
the  land  acquired.  Law  expenditures  in  connection  with  the 
organization  of  the  corporation  shall  be  charged  to  account 
'Organization.' 

"Injuries  During  Construction.  Charge  to  this  account 
all  expenditures  incident  to  injuries  to  persons  when  caused 
directly  in  connection  with  construction  of  road  and  equip- 
ment; proportion  of  salaries  and  expenses  of  physicians  and 
surgeons;  nursing  and  hospital  attendance,  medical  and 
surgical  supplies,  artificial  limbs,  railroad  and  carriage  fares 
for  conveying  injured  persons  and  attendants;  funeral  ex- 
penses (including  payment  to  undertakers)  ;  proportion  of  pay 
and  expenses  of  claim  adjusters  and  their  clerks,  and  pay  and 
expenses  of  employees  and  others  called  in  consultation  in  re- 
lation to  the  adjustment  of  claims  coming  under  this  head; 
also  witness  fees  and  amount  of  final  judgments. 

"Taxes  During  Construction.  Charge  to  this  account  all 
taxes  and  assessments  levied  and  paid  on  property  belonging  to 
the  corporation  while  under  construction  and  before  the  road 
is   opened    for   commercial    operation,    except    special   taxes 


ACQUISITION    OF   FIXED    CAPITAL  383 

assessed  for  street  and  other  improvements,  such  as  grading, 
sewering,  curbing,  guttering,  paving,  sidewalks,  etc. ;  which 
shall  be  charged  to  the  account  to  which  the  property  benefited 
is  charged. 

"Miscellaneous  Construction  Expenditures.  Charge  to 
this  account  the  salaries  and  expenses  of  executive  and  general 
officers  of  a  road  under  construction;  clerks  in  general  ofiices 
engaged  on  construction  accounts  or  work;  rent  and  repair  of 
general  offices  when  rented,  with  the  furniture  and  office  ex- 
penses; insurance  during  construction;  also  all  construction 
and  equipment  items  of  a  special  and  incidental  nature  which 
cannot  be  properly  charged  to  any  other  account  in  this  classi- 
fication. 

"Note  A. — This  account  may  include  a  suitable  proportion 
of  store  expenses  when  such  expenses  are  not  assignable  to 
specific  materials. 

"Note  B. — This  account  shall  not  include  any  costs  of  or- 
ganization, or  any  costs  or  discounts  connected  with  the  issue 
or  disposal  of  stocks,  funded  debt,  or  other  securities  and 
commercial  paper. 

"Interest  During  Construction.  Charge  to  this  account  the 
interest  accrued  upon  all  moneys  (and  credits  available  upon 
demand)  acquired  for  use  in  connection  with  the  construction 
and  equipment  of  the  property  from  the  time  of  such  acquisi- 
tion until  the  construction  is  ready  for  use.  Interest  receiv- 
able accrued  upon  such  moneys  and  credits  shall  be  credited  to 
this  account.  To  this  account  shall  also  be  credited  discounts 
realized  through  prompt  payment  of  bills  for  materials  and 
supplies  used  in  construction,  unless  such  discounts  are  credited 
to  the  particular  bills." 

In  determining  the  amount  of  capitalization  to  be  allowed 
to  cover  construction  and  related  costs,  expenses  of  the  nature 
above  described  are  only  partly  capable  of  proof.  For  instance, 
the  interest  during  construction  is  a  matter  which  can  be  com- 
puted fairly  well  barring  undue  prolongation  of  the  work,  but 


384  CAPITALIZATION 

in  greater  part  they  are  estimated  approximately  only  and  are 
based  upon  the  experience  gained  in  similar  projects.  Al- 
though at  times  the  estimates  for  each  class  of  expense  will 
be  specifically  enumerated,  in  most  instances  the  whole  amount 
necessary  to  cover  all  of  such  expenses  is  allowed  for  on  the 
basis  of  a  percentage  of  physical  construction  costs. 

But  for  how  long -a  period  may  the  salaries  of  general 
officers  and  other  expenses,  or  the  interest  paid  upon  bonds 
and  loans,  and  the  other  disbursements  above  described  be 
charged  to  capital  account,  i.e.,  be  designated  and  set  aside  as 
an  investment  upon  which  the  company  should  be  allowed  to 
earn  a  return?  The  propriety  of  charging  these  items  to 
capital  arises  in  the  first  instance  from  the  fact  that  they  are 
incidents  of  construction  costs.  But  when  is  the  justification 
removed  so  that  by  their  very  nature  they  must  be  required  to 
be  charged  against  operations  ?  The  question  suggests  its  own 
answer  in  a  general  way;  if  there  are  no  operations,  certainly 
no  expenses  can  be  charged  up  against  them.  It  may  be,  how- 
ever, that  the  lack  of  operations  is  not  due  to  the  construction 
being  unready,  but  to  some  other  cause  for  which  the  com- 
pany is  responsible  and  over  which  it  has  full  control.  Such 
circumstances  would  be  exceptional,  however,  and  where  they 
are  found  to  have  been  wilfully  produced  the  corporation  will 
certainly  be  required  to  set  up  the  expenses  in  a  separate  ac- 
count to  be  charged  against  earnings  after  operations  have 
been  commenced. 

The  greatest  difficulty  is  experienced  where  operations  and 
construction  are  intermingled.  Suppose  a  road  is  under  con- 
struction between  two  points ;  as  the  road  is  completed  to  each 
intermediate  station  along  the  route,  the  company  extends  train 
operation  to  that  station.  The  problem  for  solution  is  whether 
all  interest  payments,  for  instance,  shall  be  considered  as  no 
longer  applicable  to  construction  costs  but  to  be  charged  against 
the  operations,  even  though  operations  pertain  only  to  a  part 
of  the  proposed  construction,  or  shall  they  continue  to  be 


ACQUISITION    OF   FIXED    CAPITAL  385 

charged  in  totals  against  capital,  or,  again,  shall  there  be 
an  apportionment  and  a  part  charged  to  operation  and  the  re- 
mainder charged  to  the  construction?  The  answer  will  de- 
pend very  much  upon  the  nature  of  the  project.  If  the  section 
which  has  been  completed  can  be  considered  to  be  a  separate 
division  or  an  operating  unit,  its  construction  period  will  be 
deemed  to  have  been  closed  as  soon  as  operations  were  in- 
stituted. If  that  section  cannot  be  so  considered,  however, 
and  the  operation  of  other  parts  not  yet  completed  is  essential 
to  carry  out  the  original  intent,  incidental  operations  do  not 
affect  the  construction  period.  Aside  from  theoretical  con- 
siderations, it  will  be  the  best  policy  to  charge  some  part  of  the 
interest  against  the  operations  of  completed  parts,  if  for  no 
other  reason  than  that  of  reflecting  the  actual  costs  of  operating 
those  parts.  So  much  of  the  expenses  of  clerical  labor,  super- 
intendence, etc.,  as  are  directly  caused  by  the  conduct  of  opera- 
tions must  necessarily  be  properly  segregated  and  charged  to 
operating  expenses.  Apportionment  of  other  overhead  ex- 
penses and  the  charge  of  a  part  to  operating  expenses  should 
be  carried  out  even  though  the  net  result  of  operations  is  a  loss. 

If  the  loss  from  incidental  operations  during  construction 
period  should  prove  considerable,  under  some  circumstances 
it  will  be  quite  proper  to  charge  all  or  a  part  of  it  to  the  fixed 
capital  accounts.  In  many  quarters  "development  expenses" 
are  held  to  be  eminently  proper  charges  to  capital  under  all 
circumstances,  but  it  is  undoubtedly  the  better  practice  to  con- 
sider accumulated  deficits  chargeable  to  capital  as  the  exception 
and  not  the  rule.  Deficits  not  chargeable  to  capital  may  be  set 
up  as  a  deferred  debit  and  wiped  out  through  annual  appropria- 
tions from  the  earnings  of  the  business  after  operation  of  the 
entire  plant  is  put  under  way. 

The  charge  against  capital  account  for  interest  during  con- 
struction should  be  the  amount  of  the  actual  interest  expense 
incurred  by  the  corporation.  This  seems  an  elementary  rule; 
it  is  the  practice  prescribed  by  the  accounting  rules.    Neverthe- 


386  CAPITALIZATION 

less,  there  is  some  merit  to  the  argument  that  there  will  be  cir- 
cumstances where  the  uniform  application  of  this  rule  will 
result  injuriously  to  the  public  interest.  One  may  find  two 
similar  plants  constructed  under  almost  identical  conditions, 
but  the  one  will  have  recorded  interest  charges  much  greater 
in  proportion  to  the  total  costs  than  the  other.  The  reason  may 
be  simply  that  the  one  plant  has  constructed  its  plant  mostly 
out  of  the  proceeds  of  bonds,  while  the  other  preferred  to 
issue  more  stocks  than  bonds.  Or  the  reason  may  not  be  quite 
so  simple;  it  may  be  that  the  rate  of  interest  paid  was  exces- 
sive, not  because  of  the  market  conditions  or  the  lack  of  credit, 
but  rather  because  of  the  attempt  to  favor  certain  creditors 
who  are  affiliated  with  those  seeking  to  exploit  the  corporate 
project.  Sometimes  where  the  interest  rate  could  not  be  ques- 
tioned, objection  is  taken  to  the  amounts  borrowed ;  it  will  be 
claimed  that  more  money  had  been  borrowed  than  the  construc- 
tion immediately  in  hand  had  warranted.  As  a  matter  of  fact, 
there  will  be  very  few  instances  in  actual  practice  where  these 
questions  will  be  of  anything  more  than  academic  interest; 
only  in  "reproduction  cost"  valuations  will  any  serious  atten- 
tion need  to  be  devoted  to  the  problems  of  interest  charged  to 
construction  accounts. 

It  is  not  usual  to  carry  provisions  concerning  such  problems 
into  the  statutory  law.  In  a  federal  bill  proposed  some  years 
ago  in  relation  to  regulation  of  capitalization  by  the  Interstate 
Commerce  Commission,  there  had  been  inserted  the  following 
provision : 

"Where  any  securities  of  such  corporation  are  issued  for 
the  purpose  of  raising  money  or  to  defray  the  expenses  of  the 
construction  of  any  permanent  line  for  transportation  or  for 
the  transmission  of  intelligence  which  cannot  be  made  profit- 
able over  a  lengthened  period,  the  company  may  pay  interest 
on  so  much  of  the  cost  thereof  as  is  hereinafter  specified  out 
of  the  proceeds  of  its  stock,  charging  the  same  as  part  of  the 
cost  of  construction.    But  no  such  interest  shall  be  paid  out  of 


ACQUISITION    OF   FIXED    CAPITAL  387 

the  proceeds  of  stock  unless  the  same  shall  have  been  expressly 
authorized  by  the  Interstate  Commerce  Commission  as  neces- 
sary for  the  purpose  of  enabling  such  construction  to  be  made, 
and  the  Interstate  Commerce  Commission  shall  determine  for 
what  period  of  time  interest  may  be  paid  in  this  manner,  and 
such  period  shall  in  no  case  extend  beyond  the  close  of  the 
half  year  during  which  the  construction  shall  have  been  actually 
completed." 

§  186.     (2)  Construction  Under  Contract 

There  would  seem  to  be  no  special  problem  presented  in  the 
matter  of  capitalization  by  reason  of  the  fact  that  the  public 
utility  corporation  chooses  to  have  its  plant  built  by  contrac- 
tors rather  than  by  its  own  forces ;  in  fact,  the  greater  propor- 
tion of  railroads  and  utilities  are  now  built  by  contractors, 
and  no  questions  are  encountered  either  in  accounting  or  as  to 
capitalization.  The  instances  which  have  presented  serious 
difficulties  are  those  where  the  device  of  interior  construction 
companies  have  been  used,  i.e.,  where  a  corporation  has  been 
organized  for  the  specific  purpose  of  building  the  plant  under 
a  contract  from  the  utility  company,  both  companies  being 
under  the  same  management  and  intimately  related  to  each 
other  through  the  identity  of  officers  and  employees  who  render 
like  services  for  both.  The  existence  of  two  companies  is  a 
matter  of  form  more  than  of  substance,  and  it  is  a  device 
very  frequently  used  to  pervert  the  provisions  of  laws  govern- 
ing the  issue  of  stocks  at  par  for  cash  or  only  for  labor  done 
or  property  actually  received.  The  construction  company  re- 
ceives the  contract  under  an  agreement  that  it  shall  accept  pay- 
ment in  stocks  and  bonds.  The  par  value  of  the  stocks  and 
bonds  may  be  so  much  in  excess  of  the  probable  cost  of  con- 
struction as  to  make  it  self-evident  that  the  stock  is  being 
issued  at  a  price  much  less  than  par,  or  perhaps  for  nothing  at 
all  and  simply  as  a  bonus  to  accompany  the  bonds,  while 
the  proceeds  of  the  latter,  even  if  issued  at  a  great  discount, 


388 


CAPITALIZATION 


are  counted  upon  as  sufficient  for  the  cost  of  construction. 
Two  very  good-sized  birds  could  be  killed  with  this  stone: 
First,  the  stocks  and  bonds  could  be  marketed  upon  almost 
any  basis  at  all,  wholly  irrespective  of  statutory  restric- 
tions or  prohibitions,  with  the  incident  of  large  profits  ac- 
cruing to  those  who  as  officers  of  the  public  utility  corpo- 
ration issued  stock  to  themselves  as  officers  of  the  con- 
struction company  and  later  sold  them  upon  advantageous 
terms.  Second,  the  public  utility  corporation  can  claim 
plausibly  enough  that  the  cost  to  it  for  the  completed  plant 
has  been  the  par  value  of  the  securities  issued,  and  it  will  so 
record  the  transaction,  avoiding  a  number  of  perplexing 
problems  as  to  treatment  of  discounts,  etc.,  which  would  other- 
wise confront  it. 

The  provisions  of  public  service  commissions  laws  have 
placed  a  substantial  check  upon  the  abuse  of  construction  com- 
panies. The  Public  Service  Commission  for  the  Second  Dis- 
trict of  New  York  characterized  the  practice  as  the  employ- 
ment of  devices  "which  will  at  all  times  receive  the  condemna- 
tion of  this  Commission  so  far  as  it  has  any  power  or  juris- 
diction in  the  matter."  ^  No  objection  can  be  taken,  of  course, 
to  the  employment  of  bona-fide  construction  companies,  even 
though  payment  be  made  in  whole  or  in  part  by  the  issue  of 
securities.  Where  the  transaction  is  in  good  faith,  the  treat- 
ment of  the  cost  of  construction  carried  on  under  contract  will 
be  similar  to  the  method  of  recording  costs  of  construction  in 
the  ordinary  way  or  else  of  recording  the  purchase  price  of 
completed  plant  or  portion  of  plant. 

If  the  projected  plant  is  to  be  built  by  contract,  the  terms  of 
the  contract  will  be  placed  before  the  commission  for  con- 
sideration in  arriving  at  the  amount  of  stock  and  bonds  to  be 
authorized.  The  commission  will  inquire  fully  into  the  con- 
tract and  the  questions  which  arise  will  be  practically  those 
attending  the  estimate  of  construction  costs  with  the  added 


•Rochester,  Corning,  Elmira  Traction  Co.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.Y.)  166  (189). 


ACQUISITION    OF   FIXED    CAPITAL  389 

item  of  contractor's  profits.  The  last  item  is  a  perfectly  legiti- 
mate one,  and  a  liberal  allowance  therefor  is  often  more  to 
the  public  advantage  than  would  be  the  case  if  construction  by- 
contractors  were  discouraged  and  operating  companies  were 
required  to  build  their  own  plants.  Of  course,  there  must  not 
be  any  duplication  of  profits;  an  allowance  should  be  included 
only  where  the  utility  company  is  to  be  billed  at  cost  by  the 
contractor;  thus,  a  contract  which  specified  fixed  prices  to  be 
charged  by  the  contractors  for  the  several  parts  of  the  construc- 
tion work,  to  be  increased  by  an  allowance  for  profit,  was 
condemned  because  of  the  possibility  that  the  fixed  prices  might 
also  include  or  result  in  a  profit.  The  manner  of  recording  the 
cost  upon  the  books  should  be  just  the  same  as  though  the  com- 
pany was  doing  its  own  work  rather  than  having  it  done  by 
contractors,  and  it  will  therefore  be  necessary  that  the  former 
stipulate  that  the  contractors  shall  furnish  detailed  statements 
of  costs. 

There  may  be  instances  where  the  construction  contract 
had  become  effective  before  it  came  to  the  commission's  notice ; 
for  instance,  it  may  have  been  executed  before  the  enactment 
of  regulating  statutes  and  the  application  in  connection  with 
which  it  is  presented  for  consideration  is  one  to  issue  the 
stocks  and  bonds  necessary  to  carry  out  the  terms  of  the  con- 
tract. The  commission  cannot  exercise  any  authority  over  the 
contract,  and  the  situation  which  it  confronts  is  one  where 
obligations  have  become  fixed ;  it  will,  nevertheless,  be  justified 
in  examining  the  terms  of  the  contract  and  inquiring  into 
actual  costs  and  disbursements  so  as  properly  to  safeguard  and 
protect  its  authorization.  It  may  even  consider  the  application 
as  identical  with  one  to  issue  securities  for  the  purchase  of  a 
plant  and  apply  like  rules  for  ascertaining  values.  The  ac- 
counting method  also  will  follow  that  for  recording  the  cost 
of  the  purchased  plant  if  the  detailed  costs  of  the  construc- 
tion thereof  are  not  available  to  the  corporation  making, the 
accounting. 


390 


CAPITALIZATION 


§  187.     (3)  Purchase  of  Plant 

An  application  to  issue  stocks  and  bonds  for  the  purchase 
of  a  completed  or  going  plant  is  subject  to  somewhat  different 
considerations  from  those  already  discussed ;  these  differences 
are  due  mainly  to  the  fact  that  the  determination  of  the  amount 
required  deals  with  a  present  value  instead  of  a  cost.  The 
purchase  price  is  the  cost  to  the  purchaser,  of  course,  but  it 
may  be  much  in  excess  of,  or  less  than,  the  actual  cost  of  the 
purchased  plant.  We  are  dealing  at  this  point  with  the  transfer 
of  a  plant  already  serving  a  like  purpose  or  readily  adaptable. 
Moreover,  the  actual  transfer  of  a  physical  property  by  deed 
of  sale  is  contemplated  and  not  the  devolution  of  control  which 
may  follow  the  acquisition  of  a  majority  of  the  stock  of  an- 
other company,  or  the  automatic  transfer  of  title  incident  to 
mergers,  consolidations,  etc.  The  transfer  by  deed  incident  to 
reorganization  is  dealt  with  in  a  succeeding  chapter. 

In  most  of  the  states  where  effective  regulation  prevails 
commissions  are  given  very  complete  supervision  over  the 
transfer  of  the  plant  of  one  company  to  another.  The  express 
approval  of  the  commission  is  usually  necessary  before  the 
transfer  can  be  made  effective.  Necessarily  the  finding  that 
the  proposed  transfer  does  not  contravene  public  policy  is  a 
condition  precedent  to  the  determination  of  the  amount  of 
securities  to  be  authorized  for  issue  by  the  purchasing  com- 
pany. The  principles  of  public  policy  which  obtain  here  are 
substantially  the  same  as  in  the  case  of  consolidations  and 
intercorporate  relationships  in  general,  discussed  in  Chapter 
XVIII. 

Negotiations  for  the  sale  and  purchase  of  a  plant  are  apt 
to  cover  a  long  period  of  time  before  the  minds  of  the  inter- 
ested parties  meet  and  the  terms  are  fully  agreed  upon  and  a 
contract  executed.  Not  until  then  is  the  commission  asked  to 
authorize  the  transfer  and  the  issue  of  securities  necessary  to 
give  it  effect.  Both  requests  will  usually  be  heard  and  decided 
together.     The  contract  is  not  binding  upon  the  commission. 


ACQUISITION    OF   HXED    CAPITAL  391 

and  the  reasonableness  of  its  terms  may  be  inquired  into  very 
fully.  Where  the  contracting  parties  are  unrelated  and  the 
negotiations  have  been  bona-fide,  the  commission  will  find  some 
difficulty  in  case  of  doubt  as  to  the  reasonableness  of  the  terms, 
for  there  may  be  many  situations  where  the  price  to  be  paid 
is  admittedly  more  than  the  property  is  worth,  and  yet  the 
vendor  will  not  sell  it  for  less;  while,  if  authorization  should 
be  withheld,  an  undertaking  which  might  have  proved  very 
beneficial  to  the  public  will  be  discouraged  and  abandoned. 
Where  the  parties  are  related,  for  instance,  and  both  are  cor- 
porations controlled  by  the  same  interests,  the  "moral  suasion" 
of  the  commission,  together  with  the  suggestion  that  authori- 
zation may  be  withheld,  will  often  prove  sufficient  to  secure 
amendment  of  the  terms  of  the  contract  to  conform  with  the 
commission's  determination  of  the  value  of  the  property  and 
the  reasonableness  of  the  price  to  be  paid  and  included  in  the 
capitalization  of  the  vendee.  The  principles  which  govern  the 
inquiry  into  the  reasonableness  of  the  purchase  price  are  in 
general  the  same  as  underlie  all  valuations  of  property  for 
capitalization  purposes. 

If  the  application  for  authority  to  make  the  transfer  is 
heard  and  decided  independently,  upon  a  subsequent  hearing 
with  reference  to  the  issue  of  securities  the  contract  may  be 
brought  forward  as  conclusive  of  the  amount  necessary  to  be 
realized  through  capitalization.  If  the  commission  in  its  ap- 
proval of  the  transfer  had  knowledge  of  the  proposed  pur- 
chase price  and  the  medium  of  payment,  i.e.,  issue  of  stocks 
or  bonds  direct  to  the  vendor,  it  must  recognize  the  force  of 
that  contention  unless  it  later  finds  something  in  the  corporate 
and  financial  status  of  the  purchaser  which  justifies  a  direc- 
tion that  the  necessary  amount  be  procured  otherwise  than  by 
the  issue  of  stock  or  bonds. 

The  method  of  recording  the  purchase  in  the  capital  ac- 
counts is  governed  by  the  following  instructions  of  the  Uni- 
form Systems  of  Accounts  of  New  York: 


292  CAPITALIZATION 

other  public  service  corporations,  or  interfere  with 
the  flow  of  water  in  a  navigable  stream  to  the  ex- 
tent of  impairing  its  public  use. 
5.  Whether  there  is  any  reasonable  prospect  of  a  fair 
return  upon  the  investment  proposed,  to  the  end 
that  securities  having  apparent  worth  but  actually 
little  or  no  value  may  not  be  issued  with  our 
sanction."  * 

This  list  does  not  exhaust  the  possible  considerations,  for 
every  important  case  will  bring  its  own  individual  problems. 
In  the  words  of  the  New  Jersey  Court  of  Appeals,  it  is  the 
Commission's  duty  to  investigate  not  only  the  object  of 
the  proposed  issue  "but  the  conditions  under  which  it  is  to  be 
made,  and  the  entire  environment  of  the  company  with  its  ante- 
cedents, and  the  prospective  opportunities  it  may  encounter  in 
view  of  its  past  history,  to  meet  the  financial  demands  that  the 
proposed  burden  is  likely  to  impose  upon  it" ;  in  other  words, 
to  pass  upon  "not  only  the  legality  of  the  financial  proposition 
advanced,  but  upon  the  very  merits  of  the  subject  matter  it- 
self from  the  standpoint  of  a  wise  public  policy."  ^" 

§  149.     (3)  Limitations  Upon  Discretionary  Powers  of  Com- 
mission 

While  a  great  deal  of  discretionary  power  must  and  has 
been  allowed  to  commissions,  there  must  also  be  some  point 
where  the  grant  of  authorization  may  be  demanded  as  a  matter 
of  right.  The  statutes  do  not  deny  to  corporations  the  right 
to  issue  stocks  and  bonds ;  they  prescribe  the  purposes  for 
which  and  the  conditions  under  which  stocks  and  bonds  may 
be  issued,  and  if  an  applicant  proves  compliance  with  the  law, 
it  becomes  entitled  to  an  order  authorizing  the  issue.  Court 
decisions  in  New  York  and  elsewhere  are  in  harmony  on  this 


»  Matter  of  Hudson  River  Elec.  Pwr.  Corp.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  51   (6;). 
">  Interstate   Tel.    &   Tel.   Co.    v.    Public    Utility   Comrs.,   84   N.   J.    L.   Rep.    184;   ?6 
Atl.  Rep.  363. 


TASK    OF    PUBLIC    SERVICE    COMMISSIONS         293 

point.  The  Indiana  Supreme  Court  construes  the  statute  "of 
that  state  as  follows: 

"From  the  provisions  of  this  act  it  is  apparent  that  the 
Public  Service  Commission  is  required  to  hear  and  determine 
the  facts  upon  which  the  application  is  based,  and  the  facts 
thus  determined  constitute  the  foundation  upon  which  its  order 
shall  be  based.  If  the  facts  thus  found  are  such  as  to  entitle 
the  utility  to  a  certificate  of  authority  to  issue  and  sell  bonds 
in  a  given  amount,  it  is  the  duty  of  the  Commission  to  issue 
such  a  certificate.  Under  such  circumstances  the  act  required 
is  ministerial  and  not  discretionary.  To  hold  that  such  act  is 
discretionary  would  enable  the  Commission,  after  the  facts 
were  determined,  to  grant  the  certificate  of  authority  or  to 
withhold  it  at  its  will,  or  to  grant  such  a  certificate  to  one 
public  utility  and  to  withhold  it  from  another  under  the  same 
state  of  facts A  duty  is  none  the  less  ministerial  be- 
cause the  person  who  is  required  to  perform  it  may  have  to 
satisfy  himself  of  the  existence  of  a  state  of  facts  under  which 
he  is  given  his  right  or  warrant  to  perform  the  required 
duty."  '' 

The  Public  Service  Commission  of  Indiana,  referring  to 
its  own  powers  under  that  statute,  states: 

"We  assume  it  to  be  fundamental  that  the  legislature  could 
not,  and  has  not  attempted  to,  grant  to  this  Commission  legis- 
lative powers;  and,  further,  that  the  arbitrary  determination 
that  stocks  and  bonds  may  or  may  not  be  issued  is  the  exer- 
cise of  legislative  power,  and  any  law  which  attempted  to  place 
in  the  hands  of  this  Commission  such  arbitrary  authority 
would  be  unconstitutional.  The  law  creating  the  Public  Ser- 
vice Commission  of  the  State  of  Indiana  stipulates  when  and 
for  what  purposes  a  public  utility  corporation  may  issue  stock 


"The  statute  reads:  "If  the  Commission  shall  determine  that  such  proposed  issue 
complies  with  the  provisions  of  this  Act,  such  authority  shall  thereupon  be  granted, 
and  it  shall  issue  to  the  public  utility  a  certificate  ef  authority." 

"Public  Service  Com.  v.  State  ex  rel  Merchants  Heat  &  Light  Co.,  184  Ind.  Rep. 
273  (280). 


CHAPTER    XVIII 

INTERCORPORATE    RELATIONSHIPS,    INVEST- 
MENTS, CONSOLIDATIONS,  MERGERS, 
AND  REORGANIZATIONS 

§  189.     Intercorporate  Relationships  Defined 

Increased  capitalization  is  often  resorted  to,  and  many 
problems  of  corporate  finance  arise  out  of  the  necessity  of 
financing  the  creation  or  maintenance  of  intercorporate  re- 
lationships. 

Intercorporate  relationships  exist  where  one  corporation 
is  controlled  by  another,  or  where  two  or  more  corporations 
are  controlled  by  a  common  interest. 

Control  over  the  corporation  must  be  distinguished  from 
control  over  the  property  of  the  corporation.  Control  over 
the  corporation  is  an  incident  of  proprietorship  and  follows  the 
ownership  of  capital  stock;  this  includes,  of  course,  control 
over  the  property  of  the  corporation,  but  the  latter  may  exist 
by  virtue  of  a  contractual  relationship  only  and  without  stock 
ownership,  viz.,  through  lease,  or  any  other  agreement  by 
which  the  temporary  or  even  perpetual  control  over  the  prop- 
erty is  given  to  another  by  the  owning  corporation. 

The  report  forms  of  the  Public  Service  Commissions  of 
New  York  contain  the  following  definitions: 

"i.  Control  over  a  corporation  means  ability  to  determine, 
whether  directly  or  indirectly,  the  action  of  that  corporation. 
For  the  purposes  of  this  report,  the  following  are  to  be  con- 
sidered control: 

1.    Right,  through  title  to  securities  issued  or  assumed 
by    the   controlled    corporation,    to    exercise    the 

394 


INTERCORPORATE   RELATIONSHIPS  395 

major  part  of  the  voting  power  in  such  corpora- 
tion. 
II.  Right,  through  express  agreement  of  some  char- 
acter or  through  some  source  other  than  title  to 
securities,  to  name  the  major  part  of  the  hoard  of 
directors,  managers,  or  trustees  of  the  controlled 
corporation. 

III.  Right  to  foreclose  a  first  lien  upon  all  or  a  major 

part  in  value  of  the  tangible  property  of  the  con- 
trolled corporation. 

IV.  Right  to  secure  control  through  advances  made  for 

construction  of  road  or  other  plant  and  equipment 
of  the  controlled  corporation. 
V.    Right  to  control  only  in  a  specific  respect  or  respects 
the  action  of  the  controlled  corporation. 

"2.  Direct  control  is  that  which  is  exercised  without  the 
interposition  of  an  intermediary. 

"3.  Indirect  control  is  that  which  is  exercised  through  an 
intermediary.  Where  A  has  direct  control  over  B,  and  B  has 
direct  control  over  C,  it  will  (with  possible  exceptions  in  cases 
III  and  V  above)  be  proper  to  consider  A  as  having  indirect 
control  over  C 

"4.  Sole  control  is  that  which  rests  in  one  person,  corpora- 
tion or  other  association. 

"5.  Joint  control  is  that  which  rests  in  two  or  more  per- 
sons, corporations,  or  other  associations  (or  in  any  combina- 
tion of  two  or  more  of  these)  and  was  acquired  by  them 
through  the  same  act  or  transaction  or  through  the  same  series 
of  acts  or  transactions. 

"6.  A  proprietary  corporation  is  one  all  of  whose  stock  is 
owned  by  the  controlling  corporation  (or  corporations  in  case 
of  joint  control). 

"7.  Two  corporations  are  affiliated  when  both  are  subject 
to  the  control  of  some  third  corporation,  or  are  subsidiary  to 
the  same  controlling  interest  or  interests." 


396 


CAPITALIZATION 


Securities  of  the  controlled  corporation,  ownership  of 
which  will  give  the  controlling  corporation  right  "to  exercise 
the  major  part  of  the  voting  power  in  such  corporation," 
must  necessarily  consist  of  shares  of  stock  which  have  un- 
restricted voting  power.  For  instance,  if  the  stock  of  the 
controlled  corporation  is  divided  into  common  stock  with  full 
voting  rights  and  preferred  stock  with  limited  rights  to  be 
exercised  only  in  connection  with  specific  corporate  acts,  the 
latter  is  ineffective  for  the  purposes  of  control  against  the 
common  stock.  Securities  "assumed  by  the  controlled  cor- 
poration" can  consist  only  of  funded  debt  or  other  evidences 
of  indebtedness,  since  capital  stock  of  one  corporation  cannot 
be  assumed  by  another.  Ownership  of  bonds  does  not  carry 
with  it  control  over  the  corporation,  but  may  carry  with  it 
contingent  control  over  the  property  of  the  corporation,  and 
it  is  this  contingent  control  which  is  referred  to  in  the  third 
subdivision  of  the  first  definition  above.  There  are  many 
instances  where  a  corporation  controlling  by  stock  ownership 
also  owns  the  bonds  of  the  controlled  corporation.  In  these 
instances  the  bonds  have  been  acquired  either  as  protection 
against  the  contingency  of  other  bondholders  acquiring  con- 
trol or  possession  of  the  property  (e.g.,  through  receivership, 
etc.),  or  else  in  financing  the  enterprise  the  controlling  cor- 
poration preferred  to  issue  its  own  bonds  to  the  public  rather 
than  those  of  the  controlled  corporation,  proposing  to  hold 
the  latter  as  collateral  to  its  own  bond  issue. 

§  190.     The  Development  of  Intercorporate  Relationships 

The  power  to  purchase  and  hold  stocks  of  other  corpora- 
tions is  one  of  the  general  powers  exercised  by  practically  all 
corporations.  These  powers  must  be  considered,  however, 
in  the  light  of  statutes  restricting  combinations,  consolida- 
tions, and  mergers.  The  provisions  of  the  New  York  Public 
Service  Commissions  Law  have  already  been  quoted. 

Intercorporate  relationships  have  in  many  cases  become 


INTERCORPORATE    RELATIONSHIPS 


397 


very  complex.  The  Interstate  Commerce  Commission  on 
June  30,  191 5,  reported  that  of  $21,000,000,000  representing 
the  total  railroad  capital  outstanding  and  included  in  its  com- 
pilations, $4,800,000,000,  or  23  per  cent  of  the  whole,  was 
held  by  railroad  companies  themselves.  Of  these  holdings 
about  40  per  cent  represented  bonds  and  60  per  cent  stock  of 
the  companies. 

The  great  extent  in  which  intercorporate  relationships 
exist  has  been  due  either  to  the  attempt  to  circumvent  restric- 
tive and  special  laws  or  to  financial  expediency.  Unquestion- 
ably, too  often  they  have  been  incidents  of  improper  financing 
operations;  since  these  have  been  the  instances  about  which 
the  public  has  heard  most,  recent  legislation  in  the  public 
utility  and  other  fields  has  sought  to  eliminate  or  curb  inter- 
corporate relationships,  direct  or  indirect,  even  to  the  extent 
of  prohibiting  directors  of  certain  classes  of  corporations 
from  becoming  directors  in  certain  other  classes  of  corpora- 
tions. The  fact  of  the  matter  is  that  a  great  number  of  the 
interlocking  relationships  which  now  exist  have  been  brought 
about  by  economic  necessity  which  had  to  override  the 
barriers  of  foolish  legislation.  The  Railroad  Securities  Com- 
mission states:* 

"Some  states  have  laws  compelling  railroads  within  their 
borders  to  be  organized  under  the  laws  of  the  states  in  which 
they  are  located  and  forbidding  foreign  corporations,  so 
called,  from  constructing,  owning  and  operating  lines  thus 
located.  The  effects  of  this  and  other  similar  statutes  have 
been  largely  avoided  by  a  system  of  intercorporate  holdings, 
under  which  a  corporation  organized  in  one  state  which  owns 
the  stock  or  the  major  part  of  the  stock  of  a  road  in  another 
state  can  secure  the  capital  necessary  for  construction  or  bet- 
terment without  subjecting  itself  to  the  restrictive  laws  of  the 
state  where  the  money  is  actually  spent 

"When  the  Chicago,   Milwaukee  and   St.   Paul  railroad 

*  Pages  21  and  22  of  report. 


398 


CAPITALIZATION 


wished  to  build  its  Puget  Sound  extension  it  had  to  pass 
through  several  states  whose  laws  forbid  corporations 
chartered  under  laws  of  other  states  to  build  roads  within 
their  borders  except  as  a  connection  or  prolongation  of  a  road 
actually  built  to  the  state  line.  In  order  to  conform  to  these 
restrictions  the  St.  Paul  road  would  have  had  to  build  its 
line  slowly,  step  by  step,  instead  of  doing  work  in  several 
states  at  once  and  putting  the  road  through  as  promptly  as 
possible.  To  avoid  this  difficulty  it  had  to  organize  a  separ- 
ate company  to  build  the  road  in  each  state  which  had  such 
a  law.  This  in  itself  was  not  a  serious  evil;  it  simply  involved 
additional  expense  to  have  separate  corporations  do  things 
piecemeal  which  might  have  been  done  as  a  unit  without  such 
intermediaries.  But  it  tended  to  render  state  control  less 
effective,  instead  of  more  so.  The  system  thus  forced  upon 
the  St.  Paul  road  would  give  every  opportunity  for  deception 
to  a  road  which  might  want  to  deceive." 

Upon  the  same  point,  in  describing  the  relationship  be- 
tween the  Delaware  and  Hudson  Co.  and  two  of  its  sub- 
sidiaries, the  Quebec,  Montreal  and  Southern  Company,  and 
the  Napierville  Junction  Railway  Company,  the  New  York 
Public  Service  Commission  said:^ 

"The  construction  of  these  Canadian  roads  has  been  at 
the  instance  and  under  the  full  control  of  the  applicant.  They 
lie  in  a  foreign  country  and  the  nominal  ownership  must  be 
in  a  separate  corporation  or  corporations.  All  of  the  stock 
of  both  companies  is  owned  by  the  applicant.  The  roads  con- 
stitute valuable  extensions  of  the  applicant's  line.  They  will 
enable  it  to  reach  Montreal,  when  in  full  operation,  and  many 
other  important  points.  They  are  well  calculated  to  serve 
as  traffic  feeders  to  the  system.  It  is  important  to  the  appli- 
cant in  several  ways  that  the  bonds  or  temporary  debt  cer- 
tificates of  these  extension  lines  shall  be  in  its  possession. 
They  and  the  stock  constitute  full  ownership  in  all  but  the 

'Matter  of  Delaware  and  Hudson  Co.,  i  P.  S.  C  Rep.  (2nd  D.,  N.  Y.)  243  (274-275). 


INTERCORPORATE    RELATIONSHIPS 


399 


title  or  name.  Parenthetically,  it  may  be  observed  that,  under 
restrictive  laws  of  the  State  of  New  York,  extensions  of 
existing  railway  lines  are  necessarily  accomplished  in  sub- 
stantially the  same  way.  A  new  company  must  be  formed  of 
which  the  parent  company  takes  all  the  stock.  Construction 
funds,  in  addition  to  the  amount  represented  by  the  stock, 
must  be  provided,  and  in  return  bonds  or  debt  certificates  of 
the  subordinate  new  company  are  taken.  The  simpler  way, 
of  course,  would  be  to  permit  a  railway  to  extend  its  line, 
upon  approval  of  the  Commission,  and  raise  funds  for  the 
issuance  of  stock  or  bonds  under  an  existing  or  new  mortgage. 
The  duplication  or  double  issuance  of  capital  would  be  thereby 
avoided  and  the  necessity  of  keeping  account  for  statistical 
purposes  of  capital  issued  because  of  intercorporate  relations 
would  to  that  extent  disappear." 

§191.     Possible  Dangers  in  Intercorporate  Holdings 

It  cannot  be  gainsaid  that  the  financing  incident  to  the 
creation  and  maintenance  of  these  intercorporate  holdings 
has  been  and  will  be  used  as  a  vehicle  of  fraud  and  improper 
financial  practices  unless  wisely  regulated.  In  many  instances 
where  the  expedient  has  been  necessitated  by  the  presence  of 
laws  placing  undue  limitations  upon  the  development  of  an 
economically  sound  enterprise,  the  financing  has  been  carried 
out  in  good  faith  so  that  no  harmful  results  have  accrued 
therefrom. 

For  instance,  suppose  A  is  formed  as  a  subsidiary  cor- 
poration of  B,  with  a  total  capital  stock  of  $500,000  par  value 
and  bonds  to  the  same  amount.  A  markets  its  own  bonds 
(probably  carrying  the  guaranty  of  B  as  to  principal  and  in- 
terest or  either  of  them)  and  sells  its  entire  issue  of  capital 
stock  to  B,  the  latter  issuing  its  own  stock  (or,  following  the 
more  usual  practice,  its  collateral  trust  bonds)  sufficient  in 
amount  to  raise  the  sum  required.  The  assets  back  of  the 
increased  capitalization  of  B  consist  of  the  capital  stock  of  A, 


400 


CAPITALIZATION 


and  the  assets  back  of  the  capital  stock  of  A  consist  of  the 
proceeds  of  its  stock  and  bond  issues  and  the  other  forms  of 
capital  into  which  those  proceeds  have  been  converted.  The 
total  sum  invested  by  A  is  $1,000,000,  against  v/hich  there 
are  outstanding  its  own  securities  to  that  amount  plus  the 
$500,000  of  securities  issued  by  B  (supposing  the  latter  to 
have  been  sold  at  par).  It  would  appear  as  if  there  existed 
$500,000  of  "watered"  stock.  Such  is  not  the  fact,  however, 
since  the  entire  capital  stock  issue  of  A  remains  inactive  so 
long  as  the  corresponding  issue  of  B  remains  outstanding,  so 
that  the  total  par  value  of  securities  in  the  hands  of  the  public 
is  only  $1,000,000.  This  last  amount  could  be  increased  only 
as  B  should  sell  some  part  of  its  holdings,  in  which  case  the 
proceeds  of  the  sale  would  add  to  the  total  assets  back  of  the 
combined  capitalization  of  A  and  B,  and  if  the  latter  had 
issued  collateral  trust  bonds  instead  of  capital  stock,  it  would 
not  be  able  to  sell  any  part  of  A's  stock  held  by  it.  This  is  a 
very  simple  illustration  describing  a  situation  which  has  been 
kept  wholly  free  from  improper  practices. 

It  would  be  a  far  different  situation,  however,  if  B  had 
purchased  A's  stock  at  an  unwarranted  value,  or  else,  having 
acquired  the  stock  at  a  fair  price,  placed  an  undue  valuation 
thereupon  and  based  the  issue  of  its  own  securities  not  upon 
the  cost  but  upon  the  value  placed  upon  the  stock  acquired  and 
"written-up"  on  the  books.  In  the  former  case  it  might  be 
that  the  stockholders  of  A  proposing  to  sell  out  to  B  were 
also  stockholders  in  the  purchasing  corporation,  and  the  sale 
of  stock  was  merely  a  device  for  putting  unearned  sums  in 
their  pockets.  Or,  again,  it  might  be  that  the  officers  of  B  had 
acted  in  utmost  good  faith  but  had  been  forced  to  pay  an  ex- 
cessive price  in  order  to  shut  off  competition.  Irrespective  of 
the  purpose  and  motive,  however,  the  transaction  results  in 
the  issue  of  securities  of  B  to  an  amount  in  excess  of  the 
value  of  the  assets  owned  or  controlled.  Even  this  last  fact, 
however,  may  not  be  as  bad  as  it  looks;  it  may  be  that  A's 


INTERCORPORATE    RELATIONSHIPS 


401 


properties  bear  such  a  relation  to  those  of  B  that  the  enter- 
prise could  be  made  highly  successful  and  values  substan- 
tially increased  if  combined  under  one  management,  while  the 
independent  operations  of  each  company  would  prove  un- 
successful, if  not  wholly  destructive  of  values. 

The  issuance  by  the  controlling  corporation  of  bonds  to 
cover  its  stock  holdings  in  a  controlled  corporation  is  open  to 
the  objection  that  it  changes  the  contingent  charges  of  capital 
stock  into  the  fixed  charges  of  a  bond  issue.  It  is  hardly  fair, 
however,  to  condemn  the  practice  because  of  this  contingency, 
described  as  follows  in  the  report  of  the  Railroad  Securities 
Commission : 

"A  railroad  company  buying  the  stock  of  another  com- 
pany almost  always  issues  collateral  trust  or  other  bonds  to 
pay  for  it ;  in  other  words,  it  puts  the  stock  into  its  own  treas- 
ury and  sells  the  bonds  to  the  public.  As  long  as  the  road  is 
prosperous  this  change  does  little  harm.  In  fact,  it  may  appear 
to  do  good.  When  the  company  has  been  able  to  buy  a  5  per 
cent  stock  by  the  issue  of  its  own  4^  per  cent  bonds,  there  is  an 
apparent  profit  of  one-half  per  cent  annually  on  the  transac- 
tion to  the  company  and  an  apparent  reduction  in  the  total 
charges  which  it  must  meet.  But  with  any  diminution  in 
traffic,  the  bad  effect  of  the  change  is  at  once  obvious.  The 
interest  on  the  bonds  remains  a  fixed  charge  against  the  com- 
pany. The  effect  of  a  loss  of  dividends  would  have  been  felt 
chiefly  by  the  individual  stockholders;  a  default,  or  even  a 
threatened  default,  of  interest,  has  an  effect  on  the  credit  and 
confidence  of  the  country  as  a  whole  and  may  precipitate  a 
financial  crisis." 

Upon  the  enactment  of  the  Public  Service  Commissions 
Law,  the  New  York  Central  through  the  Mohawk  Valley 
Company,  a  non-operating  (holding)  company,  controlled  a 
number  of  electric  railroad,  electric  light,  and  gas  companies. 
It  was  claimed  that  the  provisions  of  the  new  law,  while  not 
requiring  the  Mohawk  Valley  Company  to  divest  itself  of  its 


402 


CAPITALIZATION 


Stock  holdings,  would  interfere  seriously  with  the  future 
financing  of  the  properties  and  their  legitimate  development. 
The  entire  capital  stock  of  the  Mohawk  Valley  Company  was 
then  held  by  the  New  York  Central  and  an  unincorporated 
association  called  the  Central  Railway  Syndicate;  the  former 
owning  60  per  cent  and  the  latter  40  per  cent  of  the  stock. 
A  reorganization  plan  was  worked  out  and  placed  before  the 
Commission.^  It  was  proposed  to  reduce  the  capital  stock  of 
the  Mohawk  Valley  Company  by  a  pro-rata  distribution  to 
the  stockholders  of  certain  assets  consisting  of  the  shares  of 
some  ten  different  electric  railroads.  After  the  distribution 
and  the  attending  reduction  of  stock  of  the  Mohawk  Valley 
Company,  it  was  planned  that  the  Rochester  and  Eastern 
Rapid  Railway,  one  of  the  controlled  companies,  should  in- 
crease its  capital  stock  from  $1,500,000  to  $15,290,200,  apply- 
ing the  total  amount  of  the  increase  to  the  purchase  of  the 
stocks  of  four  other  controlled  roads.  This  was  to  be  a  step 
preliminary  to  a  consolidation  of  several  of  the  companies 
in  which  the  Rochester  and  Eastern  Rapid  Railway  Company 
would  itself  participate.  The  Commission  in  its  opinion  goes 
very  fully  into  the  possible  results  of  the  increased  capitali- 
zation and  the  acquisition  of  the  stocks  of  the  other  companies 
for  the  purposes  of  control: 

"There  is  nothing  in  the  present  condition  of  this  com- 
pany (the  Rochester  and  Eastern  Rapid  Railway),  if  it  is  to 
be  considered  by  itself,  which  demands  for  the  purposes  of 
its  successful  operation  as  a  railroad  that  its  capital  stock  be 
increased.  For  certain  reasons  it  has  been  selected,  however, 
as  a  company  which  shall  become  the  owner  and  holder  of 
certain  other  railroad  stocks  which  must  be  placed  somewhere 
under  the  proposed  scheme  relative  to  the  holdings  of  the 

Mohawk  Valley  Company We  should  first  inquire  how 

public  interest  may  be  affected  by  the  proposed  large  increase 
in  the  capital  stock  of  the  Rochester  and  Eastern  Rapid  Rail- 

=  Matter  of  N.  Y.  C.  and  H.  R.  R.  R.  and  R.  and  E.  R.  Ry.  Cos.,  i  P.  S.  C.  Rep. 
(2nd  D.,  N.  Y.)  294. 


INTERCORPORATE   RELATIONSHIPS 


403 


way  Company.  It  now  has  a  stock  issue  of  $1,500,000,  which 
may  be  assumed  to  be  an  amount  proper  and  adequate  for  the 
discharge  of  its  corporate  duties  as  an  operating  company. 
The  increase  is  simply  for  the  purpose  of  owning  and  hold- 
ing the  stocks  of  other  companies.  Such  holding  cannot  in 
any  inquiry  as  to  rates  charged  by  it  constitute  an  element  in 
the  case.  In  the  determination  of  such  rates,  so  far  as  the 
amount  of  capital  stock  constitutes  a  factor  demanding  any 
consideration,  only  the  capital  stock  which  may  be  justly  said 
to  represent  the  property  operated  would  be  entitled  to  be 
regarded.  Capital  stock  which  is  issued  to  purchase  other 
stocks  must  be  eliminated  in  such  an  inquiry.  There  may  be 
serious  objection  to  constituting  an  operating  railroad  com- 
pany a  holding  company,  but  the  fact  that  its  stock  issued  for 
holding  purposes  may  be  considered  in  fixing  the  rates  it  may 
charge  for  service  is  not  an  objection.  It  may  well  be  that  as 
an  original  proposition  we  would  not  consent  to  such  an  addi- 
tion to  the  activities  of  a  railroad  company,  but  the  case  here 
presented  of  relieving  an  existing  situation,  entered  into  when 
it  did  not  have  the  disapprobation   of  the   law,   manifestly 

demands  a  different  treatment 

"Any  evil  to  the  public  must,  therefore,  be  sought  in  some 
other  direction,  and  would  consist  in  permitting  the  issue  of 
a  large  amount  of  stock  upon  a  possibly  fictitious  basis,  and 
which  ignorant  or  improvident  persons  might  be  induced  to 
purchase  at  a  price  greatly  in  excess  of  its  real  value.  This 
is  a  danger  which  this  Commission  has  certainly  endeavored 
to  guard  against  in  other  cases,  and  which  we  must  now  con- 
sider. We  believe  we  should  not  permit  an  issue  of  stock  for 
the  purchase  of  other  stock  ....  unless  the  stock  purchased 
has  value  substantially  equal  as  a  whole  to  the  par  value  of  the 

stock  issued We  must  frankly  say  that  the  means  of 

ascertaining  with  exactness  the  values  of  these  stocks  either  do 
not  exist  or  are  not  in  our  possession.  We  have  satisfied  our- 
selves, however,  from  a  consideration  of  the  towns  in  which 


404 


CAPITALIZATION 


the  properties  are  situated,  the  character  and  prospects  of  the 
communities  served,  that  these  properties  have  a  great  and 
growing  vakie.  From  a  consideration  of  the  physical  extent 
and  condition  of  the  properties,  including  the  equipment,  the 
gross  earnings  during  a  period  of  years,  the  aggregate  indebt- 
edness and  amount  of  fixed  charges,  the  aggregate  amount  of 
the  capital  stock,  the  conclusion  which  is  vigorously  urged 
upon  us  by  the  applicant  may  be  fairly  reached  that  the  value 
of  these  stocks  is  equal  to  the  par  value  of  the  stock  to  be 
issued  therefor." 

The  Commission  was  careful  to  state,  however,  that  its 
conclusion  was  not  to  be  taken  as  "an  unqualified  approval  of 
the  results  to  which  it  assents.  The  Commission  finds  itself 
confronted  with  a  situation  arising  out  of  a  change  of  law. 
That  change  of  law  compels  a  change  of  corporate  relations. 
To  some  change  it  must  assent  in  order  to  preserve  properties 
under  its  supervision  in  a  condition  to  meet  the  public  require- 
ments which  they  were  created  to  serve." 

§  192.     Capitalization  for  Purposes  of  Intercorporate  Holdings 

From  the  extended  quotations  given  above,  three  ruling 
principles  may  be  deduced: 

First,  where  authority  to  permit  or  withhold  permission 
for  the  purchase  of  stocks  of  other  companies  for  the  purposes 
of  control  is  vested  in  the  commission,  the  commission  will  be 
warranted  in  giving  its  consent  where  the  actual  consolidation 
of  the  companies  to  be  related  would  not  be  contrary  to  public 
policy. 

Second,  the  securities  to  be  issued  for  the  purpose  of  ac- 
quiring the  stock  of  the  other  companies  should  bear  a  rea- 
sonably proportionate  value  to  that  of  the  stocks  to  be  acquired. 

Third,  where  the  controlling  corporation  is  also  an  oper- 
ating company,  the  added  capitalization  shall  be  arranged  so 
as  not  to  place  an  undue  burden  upon  its  own  income  and  to 
identify  the  classes  of  stocks  or  bonds  used  for  the  acquisition 


INTERCORPORATE   RELATIONSHIPS  405 

of  operating  capital  and  those  used   for  the  acquisition  of 
stocks  and  bonds  of  subsidiary  companies. 

§  193-  (i)  Relationship  Which  Should  Exist  Between  Pro- 
jects of  Affiliated  Companies 

The  first  proposition  requires  a  similarity  and  intimacy  of 
operations  between  the  corporations  to  be  related.  In  other 
words,  there  must  be  a  reason  for  the  unification  of  interests. 
Where  the  company  to  be  controlled  is  one  newly  organized 
in  the  interest  of  the  controlling  corporation  and  for  the  pur- 
poses of  constructing  a  plant  or  railroad  which  essentially 
represents  an  extension  or  enlargement  of  the  older  company's 
project,  the  reasons  for  the  intercorporate  relationship  are 
obvious.  But  if  both  companies  have  been  conducting  opera- 
tions independently  of  each  other,  then  the  reasons  are  not  so 
easy  of  proof.  If  they  are  engaged  in  similar  businesses, 
there  should  be  physical  relationship  of  the  plants  or  some 
connection  in  the  enterprises  because  of  community  of  inter- 
ests in  the  territories  served,  or  there  should  be  some  such 
tangible  evidence  of  a  real  intimacy  between  the  operations 
of  the  two  corporations  to  justify  a  unification  of  corporate 
control  as  well.  It  has  always  been  considered  as  in  line  with 
public  policy  for  a  railroad  corporation  to  control  a  connecting 
carrier.  The  extension  of  that  principle  renders  intercorpor- 
ate relationships  proper  where  it  applies  to  corporations  whose 
properties  might  be  operated  as  a  substantial  unit,  the  one 
representing  virtually  an  extension  of  the  other. 

If  the  companies  to  be  related  are  not  engaged  in  similar 
operations,  the  one  must  have  some  necessary  relation  to  the 
other.  The  acquisition  by  one  company  of  stock  in  another 
company  operating  a  disconnected  property  may  be  a  legiti- 
mate investment  of  surplus  funds,  but  it  is  not  a  proper  pur- 
pose for  additional  capitalization.  The  New  York  Public 
Service  Commission  for  the  Second  District  thus  authorized  a 
steam  railroad  corporation  to  issue  bonds  for  the  acquisition 


406  CAPITALIZATION 

of  stocks  of  another  company  then  operating  electrically  but 
chartered  as  a  steam  railway,  on  the  ground  that  the  purpose 
in  purchasing  that  line  with  a  view  of  proposed  extension  and 
junction  with  a  third  road  "for  railroad  operations  in  connec- 
tion with  its  railroad  system  is  a  purpose  fully  recognized  by 
the  statute  as  a  proper  basis  for  railroad  capitalization."  It 
also  approved  the  issue  of  bonds  for  advances  to  connecting 
carrier  companies,  which  represented  "valuable  extensions  of 
applicant's  line."  It  refused  to  allow  capitalization  for  acqui- 
sition of  stock  in  a  traction  and  a  coal  company,  saying: 

"The  Commission  must  distinguish  between  what  are 
merely  investments  in  disconnected  properties  and  what  are 
acquisitions  of  property  having  some  definite  useful  relation 
to  the  public  service  operations  of  the  corporation."  The 
latter  were  held  to  be  "not  proper  subjects  of  capitaHzation 
under  the  provisions  of  the  statute."* 

§  194.  (2)  Value  of  Stocks  and  Bonds  Acquired  to  Support 
Those  Issued 
The  second  proposition  has  also  found  a  place  in  the  stat- 
utes of  some  states.  The  purchase  of  stock  is  the  purchase  of 
property  and,  where  more  specific  provisions  are  not  embodied 
in  the  statute,  is  subject  to  the  statutory  provisions  governing 
the  issue  of  securities  for  the  purchase  of  property.  It  would 
be  iully  covered,  for  instance,  by  the  general  provisions  of  the 
Wisconsin  law  that  "no  public  service  corporation  shall  issue 
any  stocks  or  certificates  of  stock  except  in  consideration  of 
money,  or  of  labor  or  property,  at  its  true  money  value,  as 
found  and  determined  by  the  Commission  ....  actually  re- 
ceived by  it,  equal  to  the  face  value  thereof,  nor  any  bonds, 
notes  or  other  evidence  of  indebtedness  except  for  money,  or 
for  labor  or  property  estimated  at  its  true  money  value,  as 
found  and  determined  by  the  Commission  ....  actually  re- 
ceived by  it  equal  to  not  less  than  75  per  cent  of  face  value." 

*  Matter  of  Delaware  &  Hudson  Co.,  i  P.  S.  C.  Rep.  {2nd  D.,  N.  Y.)  243  (276). 


INTERCORPORATE   RELATIONSHIPS 


407 


The  Elmira,  Corning  and  Waverly  Railway  Company  ap- 
plied to  the  New  York  Public  Service  Commission,  Second 
District,  for  permission  to  issue  bonds  in  exchange  for  the 
stocks  of  certain  other  electric  railroad  companies,^  its  purpose 
being  to  acquire  and  operate  a  continuous  line  of  street  rail- 
road. "The  first  material  inquiry,"  said  the  Commission,  "is, 
what  is  the  fair  value  of  the  stock  and  bonds  proposed  to  be 

acquired It  requires  no  discussion  to  establish  the  fact 

and,  indeed,  it  is  admitted  by  the  applicant,  that  authority  to 
issue  bonds  for  this  purpose  and  to  this  amount  should  be 
denied  unless  the  property  to  be  acquired  is  of  value  equal  to 
the  par  value  of  the  bonds  to  be  issued  therefor 

"Three  separate  hearings  were  had  upon  this  application, 
....  and  at  each  of  these  hearings  it  was  distinctly  stated 
to  the  applicant  that  it  must  establish  to  the  satisfaction  of  this 
Commission  that  the  values  of  the  properties  proposed  to  be  ac- 
quired by  it  must  be  substantially  equal  to  the  par  value  of  the 
bonds  which  it  seeks  to  issue  in  payment  therefor.  The  appli- 
cant in  no  manner  questioned  the  justice  and  propriety  of  this 
rule,  and,  in  fact,  acceded  thereto.  It  in  effect  offered  little 
direct  oral  evidence  upon  the  present  existing  values  of  the 
properties  of  the  Corning  and  Painted  Post  and  the  Waverly, 
Say  re  and  Athens  companies.  It  did  offer  the  evidence  of  one 
witness  as  to  what  in  his  opinion  the  value  of  these  properties 
would  be  after  the  construction  of  the  applicant's  road  and  the 
union  of  the  three  roads  into  one  continuous  operating  line 
under  proper  management.  This  evidence,  or  more  accurately, 
opinion,  taken  by  itself  would  apparently  support  the  con- 
tention that  the  properties  would,  under  good  management, 
be  worth  the  sum  claimed.  On  the  other  hand,  it  refrained 
from  giving  any  substantial  evidence  as  to  existing  values, 
except  such  as  could  be  deduced  from  sundry  accounts. 

"The  Commission  has  to  the  extent  of  its  power  carefully 
investigated  the  present  values  of  these  properties.     It  has  not 

0  Matter  of  Elmira,  Corning  &  Waverly  Ry.  Co.,  i  P.S.C.  Rep.  (2nd  D.,  N.  Y.)  S2&. 


4o8  CAPITALIZATION 

indulged  and  cannot  properly  indulge  in  conjectures  as  to 
values  at  some  future  time,  under  circumstances  and  condi- 
tions which  are  necessarily  unknown  to  it.  The  Commis- 
sion has  attentively  considered  all  of  the  evidence  in  the  case, 
and  is  satisfied  that  the  value  of  these  stocks,  for  which  the 
applicant  desires  to  pay  $500,000,  is  not  that  sum,  nor  does  it 
so  nearly  approach  that  sum  as  to  justify  the  Commission  in 
granting  the  application." 

Perhaps  this  is  the  statement  of  too  rigorous  a  rule.  Of 
course,  the  Commission  should  refrain  from  indulging  in  spec- 
ulation, but  it  need  not  wholly  disregard  the  probabilities  of 
enhanced  values  to  result  from  the  increased  business  or  oper- 
ating economies  following  the  unification  of  operations,  espe- 
cially where  considerations  of  public  policy  render  the  unifica- 
tion of  control  desirable.  Commissions  allow  for  probabilities 
when  they  authorize  a  new  project ;  in  the  case  of  reorganiza- 
tions, if  they  adhered  closely  to  the  rule  that  securities  of  the 
new  company  could  not  be  exchanged  for  securities  of  the 
old  company  except  upon  the  basis  of  values  then  existing, 
reorganization  would  be  impossible,  for  what  is  the  value  of 
a  bankrupt  company's  securities?  Nevertheless,  in  the  consid- 
eration of  applications  such  as  that  of  the  Elmira,  Corning 
and  Waverly  Railway  Company,  the  Commission  must  pursue 
a  rigorous  policy  because  of  the  many  opportunities  for  later 
abuse  of  its  authorization.  Where  actual  consolidation  or 
merger  does  not  result,  the  exercise  of  control  over  another 
company  is  subject  to  considerations  of  corporate  policy,  and 
corporate  policy  is  a  changeable  factor  within  the  sole  control 
of  the  company's  directors,  while  the  Commission  will  be 
practically  powerless  to  control  it  in  the  slightest  degree  if  its 
direction  is  such  as  to  defeat  the  probabilities  which  were 
urged  upon  the  Commission  and  on  the  basis  of  which  the  au- 
thorization was  made. 

The  decision  of  the  same  New  York  Commission  in  the 
Spuyten  Duyvil  and   Port  Morris  Railroad   Company   case 


INTERCORPORATE   RELATIONSHIPS 


409 


illustrates  one  method  of  valuing  stocks  proposed  to  be  ac- 
quired, as  well  as  considerations  of  public  policy  which  may 
become  controlling.  Headnote  to  the  opinion  is:  "Approval 
of  purchase  by  a  railroad  corporation  of  stock  in  another  rail- 
road corporation  where  obvious  public  advantage  is  shown." 

The  Spuyten  Duyvil  and  Port  Morris  Railroad  Company 
owned  a  short  line  of  railroad,  5.31  miles,  leased  by  the  New 
York  Central  and  used  as  a  part  of  its  main  line,  thus  consti- 
tuting "a  most  vital  part  of  the  great  New  York  Central  sys- 
tem, holding  the  key  of  its  entry  into  the  city  of  New  York." 
The  rental  paid  was  $79,120  and  the  lessee  had  expended  con- 
siderable sums  for  improvements  on  the  leased  road.  The 
New  York  Central  applied  for  permission  to  acquire  the  entire 
capital  stock  of  $989,000  par  value,  paying  therefor  at  the 
rate  of  $230  a  share,  explained  to  be  based  on  the  rental  capi- 
talized at  35^  per  cent.    The  Commission  said: 

"While  this  amount,  $2,274,700,  is  thus  over  twice  what 
the  original  investment  was,  yet  in  view  of  the  fact  that  the 
road  represents  to  the  New  York  Central  an  investment  of 
$3,191,074,  which  at  the  end  of  the  lease  will  pass  to  the 
Spuyten  Duyvil  and  Port  Morris  Railroad,  the  arrangement  is 
very  advantageous  to  the  railroad 

"Upon  consideration  of  the  above  facts  it  would  seem  as 
though  there  could  be  no  possible  doubt  or  hesitation.  How- 
ever one  may  question  the  wisdom  of  the  New  York  Central 
Company  in  1871,  when  it  entered  into  the  contract  of  the 
Spuyten  Duyvil  and  Port  Morris  Railroad  Company,  or  ques- 
tion the  policy  of  the  New  York  Central  in  having  made  such 
extensive  improvements  upon  a  right  of  way  it  did  not  own, 
and  investing  such  enormous  sums  upon  terminals  which  it 
can  reach  only  over  such  right  of  way,  yet  the  present  man- 
agement of  the  New  York  Central  is  certainly  to  be  com- 
mended for  remedying  such  a  condition  of  affairs  and  making 
the  proposed  advantageous  contract."  ^ 

«  Matter  of  N.  Y.  C.  &  H.  R.  R.  R.  Co.,  i  P.  S.  C.  Rop.  (rnd  D.  N.  Y.)  4G6 
(467,  469). 


4IO 


CAPITALIZATION 


§  195-     (3)  Company  Acquiring  Holdings  Not  to  Burden  Its 
Own  Operations 

The  third  principle  is  that  the  intercorporate  relationship 
shall  not  impose  upon  the  holding  company  an  undue  burden 
upon  its  own  income  or  earnings,  or  by  the  changing  of  con- 
tingent charges  to  fixed  charges  impose  an  undue  burden  upon 
its  own  rate-payers.  One  danger  in  changing  contingent 
charges  into  fixed  ones  has  already  been  described  in  the  quo- 
tation from  the  report  of  the  Railroad  Securities  Commission 
(see  §  191).  The  other  danger  is  that  the  holding  company 
may  seek  revenue  from  its  own  rate-payers  to  apply  to  pay- 
ments of  interest  upon  bonds  or  of  dividends  upon  stock 
issued  for  the  securities  of  controlled  corporations,  which 
have  not  been  able  themselves  to  earn  an  amount  sufficient  for 
this  purpose. 

"It  must  be  that  the  annual  charge  upon  the  gross  annual 
income  of  the  railroad  properties  of  the  applicant  for  a  pur- 
pose unconnected  with  those  properties  and  arising  wholly 
from  another  line  of  business  which  it  is  authorized  to  carry 
on,  tends  to  limit  the  amount  annually  available  for  the  proper 
management  and  betterment  of  those  properties;  that  a  lien 
upon  such  railroad  properties  for  an  indebtedness  not  con- 
nected with  them  directly  limits  by  the  amount  of  such  indebt- 
edness the  credit  of  the  applicant  in  borrowing  upon  the 
security  afforded  by  such  properties  sums  which  may  be  neces- 
sary for  their  betterment  and  improvement  and  which  would 
be  properly  chargeable  to  capital."  ^ 

§  196.     Holding  Companies 

The  preceding  discussion  has  referred  mainly  to  intercor- 
porate relationships  where  the  controlling  corporation  is  an 
operating  company,  with  a  very  slight  reference  to  the  situa- 
tion of  holding  companies.    The  problems  involved  are  almost 

^  Concurring  opinion  of  Mr.  Stevens  in  Matter  of  Delaware  &  Hudson  Co.,  i  P.  S. 
C.  Rep.   (2nd  D.,  N.  Y.)  392  U42). 


INTERCORPORATE    RELATIONSHIPS  411 

identical  in  both  situations  except  that,  since  holding  com- 
panies are  not  themselves  directly  engaged  in  active  opera- 
tions, considerations  as  to  the  effect  upon  the  income  of  the 
holding  company  are  not  of  as  great  importance.  There  are 
many  instances,  of  course,  where  an  operating  corporation 
also  performs  the  functions  of  a  holding  company,  e.g.,  the 
Rochester  and  Eastern  Rapid  Railway  Company,  described  in 

§  191- 

A  holding  company  is  one  organized  and  existing  for  the 

special  purpose  of  owning  the  shares  of  stock  of,  and  by  virtue 
thereof  controlling,  another  corporation.  It  may  be  an  oper- 
ating company  itself  or  solely  a  holding  company. 

Holding  companies  are  organized  either  to  circumvent  laws 
against  consolidations,  mergers,  etc.,  or  to  unify  under  a 
common  management  the  operations  of  companies  whose  con- 
solidation is  for  one  reason  or  another  inexpedient.  A  nota- 
ble incident  of  the  former  class  was  the  attempted  organiza- 
tion of  the  Northern  Securities  Company,  incorporated  in  1901 
in  New  Jersey.  It  acquired  control  of  both  the  Northern  Pa- 
cific Railway  Company  and  the  Great  Northern  Railway  Com- 
pany, holding  $153,750,640  out  of  $155,000,000  capital  stock 
of  the  former  and  $118,124,200  out  of  $124,109,200  of  the 
latter.  The  consolidation  of  parallel  or  competing  lines  was 
prohibited  by  some  of  the  states  crossed  by  these  railroads, 
and  the  device  of  the  holding  company  was  resorted  to  to  ac- 
complish indirectly  that  which  the  law  would  not  permit  to  be 
accomplished  directly.  In  1904  the  Supreme  Court  of  the 
United  States  ruled  that  the  control  vested  in  the  Northern 
Securities  Company  was  illegal  and  directed  the  holdings  to 
be  distributed  among  those  whom  the  court  conceived  to  be 
the  proper  owners. 

There  has  been  much  discussion  concerning  the  relative 
merits  and  demerits  of  holding  companies,  a  great  deal  of 
which  is  not  pertinent  to  this  study.  So  far  as  these  com- 
panies serve  as  a  device   for  combination,  the  problems  to 


412 


CAPITALIZATION 


which  they  give  rise  are  identical  with  those  common  to  all 
combinations. 

The  capital  of  a  holding  company  consists  of  the  shares  of 
stock  of  controlled  corporations  held  by  it;  the  value  of  its 
equity  in  the  properties  of  those  controlled  corporations  com- 
prises its  fixed  assets.  Its  income  consists  of  the  dividends 
and  interest  collected  upon  the  shares  of  stock  and  the  bonds 
held. 

In  the  financing  of  the  holding  company,  it  either  uses  its 
own  securities  in  the  direct  exchange  of  shares  to  be  acquired, 
or  else  markets  its  own  securities  and  uses  the  proceeds  for 
their  purchase.  If  the  purchase  price  has  borne  a  proper  rela- 
tion to  the  actual  value  of  the  corporate  assets  and  there  has 
been  no  "writing-up"  of  values  to  support  an  inflated  issue 
of  securities,  the  financing  is  economically  sound.  Very  often, 
however,  it  is  attempted  to  place  a  greater  value  than  the  pur- 
chase price  upon  the  shares  acquired  in  order  to  capitalize  the 
supposed  advantages  of  unifying  the  operations  of  a  number 
of  companies  and  introducing  economies  in  operation  or  effect- 
ing the  betterment  of  methods  and  processes.  It  would  be 
much  better  to  allow  the  financial  effect  of  these  advantages 
which  accrue  to  the  benefit  of  the  holding  company  to  be  ex- 
pressed in  the  earnings  and  dividends,  rather  than  in  the  capi- 
talization of  the  holding  company. 

"The  returns  to  which  a  holding  company  is  entitled  must 
depend  upon  the  returns  to  which  the  stock  held  is  properly 
entitled,  and  any  interest  of  the  public  is  confined  to  the  stock 
which  stands  as  the  representative  of  operating  property.  The 
public  pays  a  price  for  a  given  service.  That  price  may,  per- 
haps, be  greater  or  less,  according  to  the  sum  invested  in  the 
property  used  in  rendering  the  service,  and  the  amount  of 
stock  of  the  operating  company  may,  perhaps,  be  considered 
in  arriving  at  that  sum.  But  further  than  this  we  cannot  go. 
Thus  the  amount  of  stock  which  the  Rochester  and  Eastern 
Rapid  Railway  Company  chooses  to  issue  to  the  owners  of 


INTERCORPORATE    RELATIONSHIPS 


413 


stock  in,  say,  the  Oneida  Railway  Company,  can  never  be 
properly  considered  in  determining  to  what  return  the  stock 
of  the  latter  company  is  entitled.  If  the  truth  were  otherwise, 
the  returns  upon  the  stock  of  a  given  company  would  be  made 
to  depend  upon  the  prices  which  individuals  might  choose  to 
pay  for  it,  which  is  clearly  inadmissible."  ^ 
»x  The  mere  fact  that  a  person  is  a  stockholder  in  a  public 
service  corporation  does  not  bring  him  within  the  general  jur-  : 
isdiction  of  a  public  service  commission.  A  holding  company 
is  merely  a  stockholder  in  other  corporations  and  its  status  is 
not  in  any  respect  different  from  that  of  any  other  individual 
stockholder;  accordingly,  that  relationship  is  not  enough  to 
bring  a  holding  company  within  the  jurisdiction  of  a  public 
service  commission  unless  the  statute  clearly  extends  the  juris- 
diction to  cover  holding  companies." 

§  197.  Stocks,  Bonds,  or  Physical  Properties  Acquired  as 
Investments 

It  may  be  stated  as  a  general  rule  that  stock  holdings  of 
public  service  corporations  representing  the  shares  of  another 
corporation,  these  last  not  being  sufficient  in  proportionate 
number  to  carry  control  and  not  clearly  acquired  as  an  incident 
of  a  definite  program  of  securing  control,  will  be  deemed  to 
have  been  acc[uired  and  to  be  held  as  and  for  the  purposes  of 
investment.  The  same  Is  true  where,  even  if  sufficient  to  carry 
control,  the  property  or  operations  of  the  controlled  corpora- 
tion bear  no  general  relation  to  the  controlling  company's  public 
service  enterprise.  Holdings  of  bonds  and  other  certificates 
of  indebtedness  will  be  classified  according  to  whether  or  not 
there  is  attending  control  of  the  property  or  operations,  the 
necessity  of  the  control  being  judged  by  the  rule  above 
expressed. 

Stocks  and  bonds  held  as  and  for  purposes  of  investment 


8  Matter  of  N.  V.  C.  &  H.  R.  R.  R.  Co.  and  R.  &  E.  R.  Ry.  Co.'s,  i  P.'  S.  C.  Rep. 
(2nd  D.,  N.  Y.)   294  (316). 


414  CAPITALIZATION 

by  a  public  service  corporation  are  not  generally  proper  sub- 
jects of  capitalization.  Their  acquisition  should  be  financed 
out  of  surplus  profits  rather  than  out  of  funds  derived  from 
capitalization.  While  these  corporations  are  empowered  to 
acquire  and  hold  stocks  and  bonds  of  other  corporations,  they 
must  exercise  that  power  as  incidental  to  their  main  business 
of  public  service,  and  they  do  not  become  privileged  to  enter 
the  investment  field  to  any  large  extent.  If  such  a  company 
has  large  surplus  funds  which  cannot  be  advantageously  in- 
vested in  its  own  business,  it  will  serve  the  ends  of  public 
policy  better  by  a  distribution  among  stockholders  than  by 
investment  in  stocks  and  bonds  of  other  corporations. 

Subject  to  almost  the  same  considerations  as  the  foregoing 
are  investments  in  so-called  "outside  properties,"  representing 
properties  not  directly  used  or  needed  in  the  operation  of  the 
public  service  enterprise.  Very  often  the  classification  of 
properties  owned  between  those  necessary  for  the  enterprise 
and  those  representing  investments  is  a  difficult  one  to  make. 
In  the  course  of  the  valuation  of  railroad  properties  now  under 
way,  great  difficulty  is  being  encountered  in  distinguishing 
between  "carrier"  and  "non-carrier"  properties,  and  no  one 
has  succeeded  in  framing  a  rule  which  has  proved  satisfactory 
or  even  applicable  in  all  cases.  So  far  as  problems  of  capital- 
ization are  concerned,  properties,  in  themselves  unnecessary 
for  the  purposes  of  the  public  service  but  which  must  be  pur- 
chased as  a  part  of  other  properties  essential  to  that  service, 
become  proper  subjects  of  capitalization.  Having  acquired 
them  out  of  the  proceeds  of  stock  and  bond  issues,  the  cor- 
porations will  not  thereafter  be  required  to  treat  them  as  in- 
vestments made  out  of  surplus  profits.  It  would  be  reasonable 
and  very  proper,  however,  that  it  should  be  required  to  account 
for  the  proceeds  of  any  subsequent  sales  of  such  properties  by 
investing  the  proceeds  in  extension,  addition,  or  improvement 
of  its  fixed  capital;  otherwise  the  corporation  will  be  able  to 
apply  proceeds  of  capitalization  to  purposes  not  contemplated 


INTERCORPORATE   RELATIONSHIPS  415 

by  the  commission  authorizing  the  issue  of  stocks  and  bonds. 

"A  public  service  corporation  should  not  engage  perma- 
nently in  any  other  business  than  that  for  which  it  is  incor- 
porated ;  but  where  it  is  desired  to  equip  temporarily  property 
which  is  held  for  future  public  service,  and  such  property  can 
be  shown  to  be  ultimately  desirable  and  temporarily  not  a 
burden  upon  such  public  service,  this  Commission  should  not 
withhold  its  approval. 

"In  such  case  a  careful  division  of  accounts  should  be  made 
between  the  public  business  and  what  might  be  called  the  pri- 
vate business  of  the  corporation ;  and  the  latter  should  not  be 
allowed  to  become  a  drain  upon  the  public  service;  nor  by 
increasing  relatively  to  the  public  business  to  become  a  perma- 
nent business  of  the  corporation."  ^ 

Such  was  the  principle  enunciated  by  the  New  York  Public 
Service  Commission,  Second  District,  in  the  application  of  the 
Watertown  Light  and  Power  Company,  an  electrical  corpora- 
tion, for  authority  to  issue  bonds  to  discharge  certain  obliga- 
tions incurred  in  additions  and  betterments  to  its  plant,  includ- 
ing therein  additions  and  improvements  to  properties  other 
than  those  devoted  to  electrical  operations,  to  wit,  a  pulp  mill 
and  certain  real  estate.^"  The  situation  confronting  the  Com- 
mission was  a  perplexing  one. 

"Here  is  a  light  and  power  company  owning  a  pulp  mill  and 
investing  large  sums  of  money  in  developing  water  power, 
which,  whether  or  not  it  may  ultimately  be  required  for  public 
service,  is  for  the  present,  at  least,  and  for  an  indefinite  time 
in  the  future,  to  be  used  in  the  manufacture  of  pulp.  Here  is 
the  same  light  and  power  company  owning  real  estate  upon 
which  it  has  erected  a  large  building,  for  which  it  has  no  use 
at  present  in  its  public  service  capacity  and  which  it  lets  to 
numerous  tenants. 


»  Matter  of  Watertown  Light  and  Power  Co.,  i   P.  S.  C.  Rep.   (2nd  D.,  N.  Y.)   146 
(162-163). 

*"  Id.,  pages  159,  163. 


4i6  CAPITALIZATION 

"Is  this  Commission  authorized  in  approving  the  issue  of 
securities  for  such  investments?  The  Watertown  Light  and 
Power  Company,  as  a  public  service  corporation,  evidently 
cannot  borrow  money  to  make  improvements  upon  its  pulp 
mill  without  coming  to  this  Commission  for  approval,  and  it 
is  certainly  not  public  policy  to  allow  such  property  to  deterio- 
rate or  be  undeveloped ;  yet  the  purpose  has  really  nothing  to 
do  with  public  service — except  that  the  water  power  so  devel- 
oped may  at  some  future  date  be  needed  for  such  service.  It 
is  the  same  as  to  the  other  building  mentioned.  The  officers 
of  the  Watertown  Light  and  Power  Company  state  that  at 
some  future  time  they  expect  to  make  public  use  of  the  build- 
ing which  they  have  erected,  although  it  is  not  claimed  that  it 
is  in  any  way  necessary  to  their  business  at  present.  Ought 
this  real  estate  to  lie  idle  and  unremunerative  because  it  is  not 
at  present  directly  related  to  public  service?  Ought  a  public 
service  corporation  to  be  compelled  to  dispose  of  property 
which  may  become  necessary  to  its  business  at  some  future 
time  because  it  cannot  at  once  make  use  of  it? 

"It  would  seem  that  the  only  solution  of  this  question  is  to 
construe  the  act  so  as  to  allow  a  reasonable  and  intelligent 
business  judgment  to  prevail  in  such  matters;  deciding  each 
individual  case  upon  its  merits;  for  what  might  be  perfectly 
safe  and  sound  business  judgment  in  developing  a  particular 
piece  of  property  in  Watertown  might  be  very  poor  business 
judgment  in  developing  a  similar  piece  of  property  in  another 
place." 

§  198.     Consolidations  and  Mergers 

Consolidation  occurs  when  two  or  more  corporations  are 
combined  together  to  form  a  new  corporation.  The  identity 
of  the  new  corporation  so  formed  is  separate  and  distinct  from 
that  of  each  of  the  constituent  companies,  even  though  the 
name  of  the  new  company  corresponds  to  that  of  one  of  the 
consolidated  companies. 


INTERCORPORATE   RELATIONSHIPS 


417 


Merger  occurs  when  one  corporation  merges  into  itself 
another  corporation.  The  corporate  existence  of  the  merging 
corporation  is  not  affected,  while  that  of  the  merged  company 
is  absolutely  terminated  by  the  merger.  The  name  of  the 
merging  company  is  not  changed  by  the  merger. 

§  199.     (i)    Capitalization   of   Consolidating    Companies   Im- 
portant 

It  is  a  general  provision  of  corporation  laws  or  public 
utility  laws,  or  of  both,  that  the  capital  stock  of  a  consolidated 
corporation  must  not  exceed  the  aggregate  of  the  capital  stocks 
of  the  consolidating  corporations.  The  prohibition  by  its 
terms  relates  only  to  capital  stock  and  does  not  expressly  ex- 
tend to  funded  debt,  but  if  the  interpretation  of  the  Public 
Service  Com.mission  for  the  Second  District  of  New  York  in 
one  of  its  early  decisions  is  correct,  and  it  does  appear  well- 
founded,  this  prohibition  should  be  understood  to  relate  to 
the  entire  capitalization.  The  New  York  statute  reads  as 
follows : 

"Nor  shall  the  capital  stock  of  a  corporation  formed  by 
the  merger  or  consolidation  of  two  or  more  other  corporations, 
exceed  the  sum  of  the  capital  stock  of  the  corporations  so  con- 
solidated, at  the  par  value  thereof,  or  such  sum  and  any  addi- 
tional sum  actually  paid  in  cash." 

In  construing  the  above  section  of  the  statute,  the  Commis- 
sion held  that  its  policy  should  be  to  require  the  total  capital- 
ization of  the  consolidated  or  new  company,  whether  stock  or 
bonds,  issued  in  exchange  for  the  securities  of  the  old  com- 
panies, to  be  not  in  excess  of  the  total  capitalization  of  the 
consolidated  companies.     The  Commission  said: 

"The  purpose  behind  the  statute,  however,  is  perfectly 
clear.  The  provision  of  law  in  question  is  designed  to  prevent 
those  large  increases  of  capital  issues  which  have  so  often  ac- 
companied the  consolidation  of  public  service  corporations  in 
the  past,  and  which  have  imposed  heavy  burdens  on  munici- 


4i8  CAPITALIZATION 

palities  in  the  way  of  inadequate  service  and  excessive  prices 
through  the  endeavor  by  the  overcapitalized  company  to  earn 
interest  and  dividends  on  the  excessive  issue  of  securities.  If 
this  beneficent  purpose  of  the  statute  can  be  evaded  ....  by 
leaving  the  aggregate  capital  stock  unchanged,  but  imposing 
the  same  burden  upon  the  community  through  a  greatly  in- 
creased issue  of  bonds,  the  statute  totally  fails  to  accomplish 
the  intended  purpose."  ^^ 

The  requirement  that  the  total  capitalization  of  the  new 
corporation  shall  not  exceed  the  aggregate  of  the  stock  and  the 
bond  issues  of  the  consolidated  companies  does  not,  of  course, 
set  any  limitation  upon  the  action  of  the  corporation  to  increase 
its  capitalization.  The  new  corporation  immediately  after  the 
consolidation  is  consummated  may  increase  its  capitalization, 
or  the  increase  may  even  be  made  as  an  incident  of  the  con- 
solidation proceedings.  The  purpose  of  the  increase  must  not 
be  related  to  the  consolidation  itself,  however,  but  rather  to 
the  extensions  or  improvements  to  be  added  to  the  consolidated 
properties. 

Neither  does  the  prohibition  contemplate  that  the  stock  of 
each  of  the  constituent  companies  shall  be  exchanged  on  equal 
terms.  The  stock  of  one  may  be  exchanged  at  par,  while 
that  of  the  other  will  be  at  below  or  above  par;  any  ratio  of 
exchange  may  be  adopted  to  produce  a  fair  and  equitable  read- 
justment of  interest  and  control  in  the  new  corporation  by  the 
stockholders  of  the  old  corporations. 

Nor  does  the  prohibition  affect  in  any  way  the  capitaliza- 
tion of  a  merging  corporation.  A  merging  corporation  is 
required  to  be  in  possession,  before  the  merger,  of  every  share 
of  the  capital  stock  of  the  company  to  be  merged.  In  the  ac- 
quisition of  that  stock  it  may  have  issued  its  own  securities  or 
utilized  its  surplus  assets,  but  when  it  has  acquired  all  of  the 
capital  stock  the  fact  of  merger  does  not  present  any  occasion 
for  disturbing  the  capitalization  of  the  merging  company. 

"  Matter  of  Lockx)ort  Light,  Heat  and  Power  Co.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.) 
12  (20). 


INTERCORPORATE   RELATIONSHIPS 


419 


Where  public  utility  laws  are  in  force,  all  consolidations 
and  mergers  are  subject  to  the  approval  of  the  commission. 
Special  statutes  control  in  many  states,  and  the  anti-trust  laws 
of  states  and  of  the  federal  government  against  combinations 
obtain  with  full  force. 

In  the  Lockport  case  mentioned  above,  the  attempt  was 
made  to  avoid  the  prohibition  of  the  statute;  each  corporation 
included  in  the  unifying  scheme  was  to  sell  its  property  and 
franchises  to  a  newly  organized  corporation.  While  admitting 
that  technically  this  was  neither  a  consolidation  nor  a  merger, 
the  Commission  characterized  the  project  as  one  "effecting 
consolidation  by  the  use  of  a  newly  organized  purchasing 
company,  without  technical  merger  or  consolidation  of  the 
existing  companies,"  and  for  the  purpose  of  giving  effect  to 
the  statute  treated  the  application  before  it  as  one  relating  to 
consolidation. 

§  200.  (2)  When  Values  of  Consolidating  Properties  Need  to 
Be  Considered 

The  underlying  purpose  of  the  statute  limiting  the  capital- 
ization of  the  consolidating  corporation  is  to  protect  against 
overcapitalization.  But  this  overcapitalization  may  be  accom- 
plished not  only  by  the  issue  of  securities  in  excess  of  the 
capitalization  of  the  consolidated  companies,  but  also  by  carry- 
ing into  the  consolidating  company  the  overcapitalization 
already  existing  in  one  of  the  consolidated  companies.  In  the 
attempt  to  have  the  consolidated  company  kept  free  of  over- 
capitalization, it  is  a  reasonable  and  proper  policy  for  the  regu- 
lating commission  to  inquire  into  the  capitalization  of  the 
consolidating  companies.  The  Commission  "will  consider  the 
relation  of  the  value  of  the  constituent  properties  to  the  pro- 
posed capitalization  of  the  new  or  consolidated  company  (in- 
cluding when  necessary  in  such  valuation  an  allowance  for 
intangible-  matters,  and  also  allowing  in  the  comparison  for 
discount  on  the  sale  of  bonds),  in  order  that  the  Commission 


420  CAPITALIZATION 

may  act  with  understanding,  and,  if  warranted  thereby,  disap- 
prove a  consoHdation  plan  providing  large  capitalization  and 
relatively  small  property  value."  ^^ 

"If  it  does  not  appear  that  the  combining  of  the  stock, 
bonds,  and  outstanding  indebtedness  of  the  three  companies 
would  exceed  the  fair  valuation  of  the  combined  plants,  or  that 
the  value  of  any  one  of  such  plants  is  greatly  less  than  its 
capitalization  and  floating  debt,  so  that  the  consolidation 
would  diminish  the  resources  for  the  service  and  operation 
in  fields  now  occupied  by  others,  or  that  the  public  interest 
would  be  otherwise  adversely  affected,  these  companies  should 
under  the  facts  above  stated  be  permitted  to  consolidate 

"From  an  examination  of  the  properties  by  our  engineers 
and  an  examination  of  the  books  and  records  of  the  companies 
by  our  special  examiner,  we  are  satisfied  that  the  value  of  the 
Newburgh  and  Poughkeepsie  properties  for  the  purposes  of 
this  case  is  in  excess  of  the  stock  and  bond  capital  and  the 
excess  of  bills  and  accounts  payable  over  bills  and  accounts 
receivable.  Such  examinations  indicate,  however,  that  certain 
changes  in  bookkeeping  are  important  and  necessary  in  order 
that  the  facts  involved  may  be  more  clearly  shown  and  true 

surplus  be  stated We  think  the  financial  and  income 

statements  fairly  warrant  the  consolidation,  if  the  proper 
amounts  are  written  off  from  the  Fixed  Capital  accounts. 
....  The  necessity  for  a  revision  of  accounts  at  this  time  is 
demonstrated  by  the  fact  that  it  would  be  practically  impossible 
to  require  such  revision  after  a  consolidation."  ^^ 

§  201.     (3)   Considerations  of  Public  Policy 

In  the  concurring  opinion,  Mr.  Stevens  thus  summarized 
the  elements  of  public  interest  to  be  inquired  into:  "In  the 
case  of  the  proposed  consolidation,  if  the  Commission  can  see 

'^Headnote  to  Matter  of  Wayne  County  Gas  Co.,  2  P.   S.  C.  Rep.    (:;nd  D.,  N.   Y.) 

TvT  ''.Matter  of  Poughkeepsie  Light,  Heat  and  Power  Co.,  2  P.  S.  C.  Rep.  (^nd  D.. 
A.   1.)  64::^  (649,-657).  ^'    ^         "'' 


INTERCORPORATE   RELATIONSHIPS 


421 


that  such  consolidation  may  have  a  tendency  to  impair  the 
service  or  to  produce  unreasonable  rates,  or  to  impair  the  value 
of  the  securities  offered  by  the  corporation  for  sale  to  the 
public,  then  it  is  the  duty  of  the  Commission  to  place  its  nega- 
tive upon  the  contemplated  action.  If  it  cannot  see  that  any 
results  of  this  character  might  ensue,  or  if  they  did  ensue  that 
it  would  be  unable  to  deal  with  them  properly  and  effectually, 
I  am  unable  to  perceive  how  it  can  justify  itself  in  denying  the 
corporations  the  right  to  exercise  the  privilege  conferred  upon 
them  by  law.  There  certainly  must  be  a  reason  for  exercising 
the  negative  of  the  Commission,  and  I  cannot  believe  that  any 
reason  is  adequate  unless  it  is  something  which  makes  pos- 
sible remediless  evil  against  public  interest,  or  makes  difficult 
or  impossible  the  proper  and  effective  application  of  ipublic 
control."  " 

One  way  in  which  consolidation  may  make  difficult  the 
application  of  public  control  lies  in  the  massing  of  accounts 
covering  possibly  several  municipalities  wherein  different  rates 
are  charged  or  different  conditions  of  rendering  service  pre- 
vail, so  that  upon  an  inquiry  into  rates  the  Commission  might 
be  confronted  with  a  situation  where  the  costs  of  service  and 
the  value  of  separate  plants  in  the  several  municipalities  could 
not  be  determined.  To  safeguard  against  this  the  Commission 
has,  in  a  number  of  cases,  required  the  consolidated  company 
to  keep  its  accounts  separately  for  the  territories  served  by  the 
constituent  companies.  There  is  no  reason  why  such  require- 
ments should  be  made  only  of  consolidated  companies;  both 
the  public  and  corporate  interests  are  better  served  where 
costs  of  service,  so  far  as  they  may  be  allocated,  applicable  to 
separated  communities  are  kept  by  themselves.  Such,  in  fact, 
is  the  usual  practice;  the  problem  is  not  so  much  the  introduc- 
tion of  a  new  method  as  the  perfection  of  the  existing  meth- 
ods through  better  records  and  more  correct  bases  of  allocating 
"overhead"  and  general  expenses. 

^*  Matter  of  Poughkeepsie  Light,  Heat  and  Power  Co.,  2  P.  S.  C.  Rep.  (2nd  D., 
N.  Y.)  644)  (661). 


422 


CAPITALIZATION 


§  202.     Corporate  Reorganizations 

The  control  of  the  issues  of  stocks  and  bonds  in  reorgan- 
ization proceedings  is  one  of  the  most  important  aspects  of 
regulation.  The  financing  of  reorganizations  has  heretofore 
been  a  very  loose  and  elastic  thing;  since  it  almost  always  re- 
sulted from  the  compromise  of  conflicting  interests,  it  seldom 
was  made  responsive  to  any  fixed  principles.  The  necessity 
for  reorganization  has  usually  been  the  result  of  bondholders' 
demands  and  inability  of  the  company  to  meet  the  current 
fixed  charges,  or  else  the  maturity  of  principal.  In  such  case  the 
inability  denotes  lack  of  credit  because  of  earnings  insufficient 
to  care  properly  for  the  fixed  charges  and  to  leave  an  ade- 
quately protective  surplus  besides,  and  the  one  purpose  which 
has  been  common  to  most  reorganizations  has  been  that  of 
cutting  down  the  amount  of  fixed  charges  to  be  required  by 
the  new  capitalization.  This  has  required  the  new  bond  issue 
to  be  smaller  than  the  old,  but  to  satisfy  the  bondholders  for 
the  destruction  of  their  claim,  they  were  given  shares  of  stock 
instead,  most  often  the  par  value  of  the  shares  offered  exceed- 
ing the  par  value  of  the  bonds  cancelled.  The  general  result 
has  been  that  a  company  going  through  reorganization  came 
up  at  the  termination  of  the  process  with  a  total  capitalization 
very  much  greater  than  the  old  capitalization.  In  many  cases 
the  process  has  been  repeated  over  and  over  again,  and  each 
instance  has  been  the  occasion  for  increased  capitalization. 

The  term  "reorganization"  may  be  used  in  several  different 
meanings.  It  may  refer  to  a  reorganization  of  the  finances 
by  agreement  among  the  stockholders,  bondholders,  and  other 
claimants.  Such  a  reorganization  would  come  before  a  regu- 
lating commission  largely  as  an  application  to  undertake  fund- 
ing and  refunding  operations,  to  issue  stocks  and  bonds  for 
the  purpose  of  acquiring  new  capital,  or  for  the  maintenance 
or  improvement  of  service,  etc. 

Reorganization  may  also  refer  to  instances  where  through 
intercorporate  relationships  the  financial  affairs  of  one  of  the 


INTERCORPORATE   RELATIONSHIPS  423 

companies  are  recast  and  its  properties  and  operations  modi- 
fied. There  is  no  corporate  reorganization  here,  and  so  far 
as  there  may  be  reorganization  of  finances  the  incidents 
thereof  will  be  identical  with  those  described  in  the  above 
paragraph.  Sometimes  the  changing  of  company  directors 
and  officers  is  spoken  of  as  a  corporate  reorganization,  while 
it  represents  merely  reorganization  of  operations  and  man- 
agement. 

Corporate  reorganization  is  the  usual  result  of  bankruptcy 
and  foreclosure.  A  company  defaulting  on  its  obligations  has 
its  properties  placed  in  a  receivership,  and  ultimately  sold 
pursuant  to  an  order  of  the  court.  The  statute  then  empowers 
the  purchaser  at  such  sale  to  associate  with  others  into  a  new 
corporation  to  succeed  to  all  the  properties,  franchises,  and 
rights  which  were  included  in  the  sale.  The  purchaser  very 
frequently  represents  bondholders  of  the  bankrupt  company, 
who  by  taking  over  the  property  for  operation  hope  eventually 
to  save  themselves  from  loss.  The  new  company  is  then  called 
upon  to  provide  for  the  payment  of  the  purchase  price,  to  be 
carried  out  in  large  measure  by  the  exchange  of  securities,  and 
to  raise  new  capital  to  improve  the  properties,  continue  the 
operations,  and  in  general  to  get  a  new  start  in  the  business. 
The  plan  will  have  been  agreed  upon  in  advance,  but  where 
there  are  many  classes  of  bondholders,  secured-note  holders, 
etc.,  to  be  brought  within  the  agreement,  the  financing  problem 
becomes  quite  complicated. 

The  New  York  statute  as  at  first  enacted  was  held  by  the 
courts  to  be  ineffectual  in  conferring  upon  the  commissions 
jurisdiction  over  these  reorganization  proceedings,  and  the 
defect  was  made  good  by  an  amendment  which  reads:  "Re- 
organization ....  shall  be  subject  to  the  supervision  and 
control  of  the  proper  commission  and  no  such  reorganization 
shall  be  had  without  the  authorization  of  such  commission. 

"Upon  all  such  reorganizations  the  amount  of  capitaliza- 
tion, including  therein  all  stocks  and  bonds  and  other  evidence 


424  CAPITALIZATION 

of  indebtedness,  shall  be  such  as  is  authorized  by  the  commis- 
sion which,  in  making  its  determination,  shall  not  exceed  the 
fair  value  of  the  property  involved,  taking  into  consideration 
its  original  cost  of  construction,  duplication  cost,  present  con- 
dition, earning  power  at  reasonable  rates  and  all  other  rele- 
vant matters  and  any  additional  sum  or  sums  as  shall  be  actu- 
ally paid  in  cash,  provided,  however,  that  the  commission  may 
make  due  allowance  for  discount  of  bonds.  Any  reorganiza- 
tion agreement  before  it  becomes  effective  shall  be  amended 
so  that  the  amount  of  capitalization  shall  conform  to  the 
amount  authorized  by  the  commission." 

Both  the  First  and  Second  District  Commissions  in  exer- 
cising authority  over  the  capitalization  of  reorganized  com- 
panies had  held,  before  the  enactment  of  this  amendment,  that 
the  stocks  and  bonds  to  be  issued  should  bear  a  distinct  rela- 
tion to  the  value  of  the  properties  to  be  acquired.  So  far  as 
the  authority  of  the  statute  was  concerned,  the  purpose  of  issue 
was  assumed  to  be  "the  acquisition  of  property."  The  Second 
District  Commission  accordingly  held  that  the  reorganized 
company  could  be  authorized  to  "issue  stock  and  bonds  for 
the  acquisition  of  the  property  of  the  corporation  which  was 
sold  upon  judicial  sale ;  that  such  stock  and  bonds  may  be  au- 
thorized to  the  amount  of  the  fair  value  of  the  property  sold 
upon  such  judicial  sale,  and  that  such  property  must  be  either 
tangibles  or  such  intangibles  as  constitute  a  right  to  demand 
and  receive  or  otherwise  enjoy  the  possession  of  tangible 
property."  ^^ 

The  Court  of  Appeals  in  overruling  the  decision  of  the 
First  District  Commission  in  the  Third  Avenue  Railway  Com- 
pany case  held  that  the  capitalization  of  a  corporation  formed 
on  the  reorganization  of  a  foreclosed  railroad  did  not  depend 
upon  the  value  of  the  property,  and  that  there  was  no  rule  of 
law  or  statute  requiring  the  capitalization  to  be  scaled  down 
to  the  actual  value  of  the  property.     In  this  respect  the  status 

1^  Matter  of  Genesee  Light  &  Power  Co.,  .'  P.  S.  C.  Rep.  (jnd  D.,  N.  Y.)  413  (48^). 


INTERCORPORATE    RELATIONSHIPS 


425 


of  the  reorganized  company  was  likened  to  the  situation  of  a 
consohdated  company  whose  capital  stock  was  reciiiired  by  law 
not  to  exceed  the  aggregate  capital  stock  of  the  consolidating 
companies,  there  being  no  reference  to  the  value  of  the  prop- 
erties; thus  indicating  a  policy  of  the  law,  in  some  cases  at 
least,  to  ignore  the  value  of  the  properties  acquired  on  a  test 
of  the  amount  of  securities  to  be  issued.  The  subsequent 
amendment  of  the, statute,  however,  specifically  provided  that 
the  capitalization  of  the  new  company  should  not  exceed  "the 
fair  value  of  the  property  involved,  taking  into  consideration 
its  original  cost  of  construction  .  .  .  ." 

The  value  of  the  properties  of  a  bankrupt  railroad,  gas,  or 
power  company  would  be  difficult  of  determination.  Take  a 
property  very  expensively  constructed  and  for  a  volume  of 
business  far  in  excess  of  that  which  has  yet  been  developed. 
The  capitalization  has  been  conservative  and  does  not  exceed 
either  the  cost  to  build  or  the  present  cost  to  reproduce,  and 
if  the  expected  volume  of  business  had  developed  there  would 
have  been  no  difficulty  in  meeting  all  obligations.  The  com- 
pany becomes  financially  embarrassed,  defaults  on  its  pay- 
ments, and  the  plant  is  foreclosed.  To  insist  that  the  securi- 
ties of  the  new  company  shall  not  exceed  the  value  of  the 
foreclosed  property,  judging  of  that  value  either  by  cost  to 
build  or  reproduce,  since  no  other  index  is  available,  would 
not  help  in  the  slightest.  The  real  considerations  in  reorgan- 
ization cases  will  often  be  very  complex;  the  mistakes  of 
management,  the  reasons  for  inadequate  business,  the  condi- 
tion of  plant,  the  prospects  for  favorable  development,  etc., 
all  will  need  investigation  and  may  present  very  forceful  con- 
siderations. It  is  best,  in  view  of  these  facts,  that  special 
powers  should  be  conferred  upon  commissions  in  dealing  with 
reorganization  cases.  Perhaps  in  no  other  class  of  cases  deal- 
ing purely  with  capitalization  may  the  commission  exercise  as 
great  a  constructive  influence. 


CHAPTER    XIX 

CAPITALIZATION    FOR    SUNDRY    PURPOSES 

§  203.     Reimbursement  of  Moneys  Expended  from  Income 

An  operating  corporation  will  constantly  make  minor  ad- 
ditions to  its  fixed  capital,  the  expenditures  for  which,  paid 
out  of  current  income,  may  ultimately  amount  to  a  consider- 
able sum ;  or  it  may  undertake  an  extension  or  addition  to  its 
plant  and  likewise  meet  the  cost  out  of  current  income  or 
accumulated  surplus,  rather  than  from  the  immediate  issue  of 
stocks  or  bonds.  In  either  case  the  corporation  expects 
eventually  to  capitalize  these  expenditures,  that  is  to  say,  to 
issue  stocks  or  bonds  or  both  for  such  an  aggregate  amount 
as  it  would  have  been  authorized  to  issue  in  the  first  instance 
if  it  had  proposed  to  pay  for  these  projects  out  of  the  pro- 
ceeds of  capitalization.  However,  the  question  of  intent  is 
not  at  all  controlling,  and  the  expenditures  may  be  capitalized 
even  though  there  had  been  no  original  intent  to  do  so.  The 
expenditures  may  even  have  been  charged  to  operating  ex- 
penses because  it  was  not  supposed  that  they  would  ever  be 
capitalized.  Of  course,  where  this  last  situation  obtains,  the 
accounts  must  be  restated  before  or  concijrrently  with  the 
capitalization  of  the  expenditures. 

Expenditures  which  were  actually  made  and  were  such 
that  they  could  properly  have  been  or  were  charged  to  capital 
accounts,  may  be  capitalized  under  the  public  service  com- 
mission laws  of  the  several  states  permitting  capitalization 
"for  the  reimbursement  of  moneys  actually  expended  from 
income  ....  or  from  any  other  moneys  in  the  treasury  of 
the  corporation  not  secured  by  or  obtained  from  the  issue  of 
stocks,   bonds,   notes   or   other   evidence   of   indebtedness  of 

426 


CAPITALIZATION   FOR   SUNDRY    PURPOSES  427 


such  corporation,   for  any  of  the  aforesaid  purposes  except 
maintenance  of  service  and  except  replacement.' 


>'  1 


§  204.  (i)  Capitalization  for  This  Purpose  a  Limited  Right 
These  appropriations  of  income  represent  contributions  of 
stockholders  just  as  much  as  if  they  had  made  direct  pay. 
ments  to  the  corporations.  The  stockholders  could  have  with- 
drawn the  earnings  in  the  first  instance  if  they  had  chosen  to 
make  direct  contributions  or  to  secure  advances  on  stock  and 
bond  issues  for  the  cost  of  the  new  construction,  and  they 
may  therefore  do  so  at  any  later  time  unless  there  is  a  specific 
prohibition  or  time  limitation  of  the  statute.  The  New  York 
statute,  for  instance,  limits  capitalization  for  reimbursement 
of  income  to  moneys  "actually  spent  from  income  within  five 
years  next  prior  to  the  filing  of  an  application."  The  con- 
tinued existence  of  the  right  without  some  definite  limitation 
would  tend  to  defeat  the  real  purpose  of  the  law,  which  is  that 
of  controlling  capitalization  by  regulating  the  expenditures 
of  the  proceeds.  That  purpose  could  not  be  carried  out  if 
the  corporations  were  permitted  to  go  ahead  and  make  ex- 
penditures upon  projects  which  will  come  before  the  Com- 
mission for  examination  only  after  completion,  and  after 
liabilities  have  been  incurred  and  contractual  obligations  as- 
sumed which  will  seriously  hamper  the  consideration  of  the 
merits  or  necessity  of  the  project.  On  the  other  hand,  to 
restrict  the  right  of  issuing  stocks  and  bonds  to  meet  future 
expenditures  alone  will  do  more  harm  than  good;  some 
measure  of  freedom  has  to  be  extended  to  corporations  to 
make  needed  improvements  and  replacements  without  the  de- 
lay of  formal  applications  and  hearings.  The  authority  must 
not  be  abused,  however,  and  important  projects  which  will 
ordinarily  require  long  periods  of  deliberation  and  investiga- 
tion, and  involve  relatively  large  sums,  should  not  be  under- 
taken under  this  clause. 


^  Quotation  from  New  York  statute. 


428  CAPITALIZATION 

The  New  York  statute  made  provision  for  capitalization 
to  reimburse  income  for  all  proper  expenditures,  without  any 
limitation  to  a  five-year  period,  provided  application  was  made 
before  January  i,  19 12.  This  temporary  authority  was  neces- 
sary to  afford  an  opportunity  to  those  corporations  which 
had  financed  or  were  then  financing  additions  and  betterments 
out  of  income  to  carry  out  their  plans  while  adjusting  them- 
selves to  the  new  requirements.     The  statute  reads: 

"Nothing  herein  contained  shall  prohibit  the  Commission 
from  giving  its  consent  to  the  issue  of  bonds,  notes  or  other 
evidence  of  indebtedness  for  the  reimbursement  of  moneys 
heretofore  actually  expended  from  income  for  any  of  the 
aforesaid  purposes  (accjuisition  of  property,  construction, 
etc.),  except  maintenance  of  service  and  replacements,  prior 
to  five  years  next  preceding  the  filing  of  an  application  there- 
for, if  in  the  judgment  of  the  Commission  such  consent  should 
be  granted ;  provided  application  for  such  consent  shall  be 
made  prior  to  January  first,  nineteen  hundred  and  twelve."  ^ 

§  205.     (2)  Effect  of  Reimbursing  Income  by  Stock  Issue 

If  the  expenditures  for  which  income  is  to  be  reimbursed 
have  been  charged  to  capital  account,  they  have  added  to 
surplus;  if  they  have  been  charged  to  expenses,  they  must  be 
transferred  to  capital  account  if  reimbursement  is  to  be  made 
through  capitalization,  thereby  adding  to  surplus.  To  reim- 
burse the  treasury  of  the  corporation  from  the  proceeds  of 
capitalization  is  to  reimburse  the  stockholders,  since  the  pro- 
ceeds go  into  the  treasury  and  there  become  available  for  any 
purpose  whatsoever,  most  usually  being  used  for  distribution 
as  special  dividends.  An  authorization  to  issue  stocks  or 
bonds  to  reimburse  the  treasury  is  necessarily  a  finding  that  a 
definite  amount  of  the  stockholders'  present  equity  represents 
earnings  of  the  enterprise  retained  by  the  corporation.     Sup- 

"  The  New  York  Public  Service  Commissions  Law  took  effect  July  i,  19071,  for  all 
classes  of  corporations  except  telephone  and  telegraph  corporations,  and  as  to  the  latter 
it  took  effect  September  i,  1910. 


CAPITALIZATION    FOR    SUNDRY    PURPOSES 


429 


pose  that  equity  to  be  $50  per  share  represented  by  expendi- 
tures in  plant.  The  sole  purpose  of  issuing  stocks  or  bonds 
against  this  $50  is  to  make  this  increased  equity  available  to 
the  stockholder  in  one  way  or  another.  The  corporation  may 
issue  stock  for  the  amount  and  present  the  stock  certificate  to 
the  stockholder  as  a  special  dividend  and  thus  make  the  equity 
available  to  him  in  a  certificate  of  increased  proprietorship 
which  he  may  either  hold  or  dispose  of,  just  as  he  pleases. 
Or  the  corporation  may  issue  the  stock  and  offer  it  for  sale ; 
if  it  is  all  taken  up  by  the  stockholders  to  whom  it  is  first 
offered,  each  one  will  contribute  $50  for  every  share  of  stock. 
If  a  special  dividend  of  the  full  amount  of  the  proceeds  is 
then  declared  and  paid,  the  stockholders  will  receive  a  divi- 
dend of  $50  for  each  share  owned;  the  net  result  will  be  the 
same  in  every  way  as  if  a  stock  dividend  had  been  declared. 
But  if  the  proceeds  are  not  divided  among  the  stockholders, 
their  equity  will  remain  precisely  as  it  was  before  the  issue 
of  the  new  stock.  If  the  new  stock  is  taken  up  by  others  than 
the  existing  stockholders,  or  if  bonds  are  issued  and  the  pro- 
ceeds used  for  a  special  dividend,  the  stockholder  will  re- 
ceive $50  in  cash  and  the  value  of  his  holdings  will  go  back 
to  what  it  was  before  the  increased  equity  arising  from  the 
application  of  earnings  to  capital  expenditures  was  made. 
In  other  words,  that  portion  of  the  increased  equity  is  made 
available  to  him  in  cash,  while  if  the  proceeds  are  not  divided 
among  the  stockholders  but  used  in  the  regular  course  of  cor- 
porate business,  his  equity  will  remain  undisturbed. 

§  206.  (3)  Analysis  of  Accounts  to  Determine  Amount  to  Be 
Reimbursed 
Accounting  methods  have  not  developed  so  far  as  to 
make  possible  the  tracing  of  expenditures  to  definite  sources 
of  the  funds  used  therein;  consequently  it  is  impossible  to 
secure  by  mere  examination  of  capital  or  cash  accounts  definite 
information  that  the  expenditures  were  made  out  of  income. 


430 


CAPITALIZATION 


A  conclusion  as  to  the  source  of  the  funds  with  which  the 
expenditures  were  paid  is  a  general  conclusion  from  a  study 
of  all  the  accounts  and  is  arrived  at  by  a  process  of  elimina- 
tion. The  conclusion,  therefore,  will  better  reflect  the 
process  of  elimination  by  which  it  was  reached  if  it  is  stated 
in  terms  that  the  expenditures  were  not  paid  out  of  the  pro- 
ceeds of  stocks,  bonds,  or  other  evidences  of  indebtedness, 
instead  of  saying  that  they  were  paid  out  of  earnings.  The 
New  York  Public  Service  Commissions  Law  properly  re- 
flects this  difficulty  of  identifying  the  source  of  funds  in  the 
phrase  "expended  from  income  ....  or  from  any  other 
moneys  ....  not  secured  by  or  obtained  from  the  issue  of 
stocks,  bonds,  notes  or  other  evidences  of  indebtedness  of  such 
corporation."  Yet  it  may  be  that,  while  the  moneys  expended 
had  not  been  secured  from  the  issue  of  stocks,  bonds,  etc., 
income  may  not  be  reimbursed  for  the  expenditures  by  the 
application  of  the  proceeds  of  capitalization,  for  it  may  be 
that  the  expenditures  represent  the  investment  of  special 
funds ;  for  instance,  a  fund  set  aside  for  accrued  depreciation 
which  has  been  invested  in  plant  rather  than  in  securities  or 
other  properties,  so  that  under  these  circumstances  the  fund 
is  not  permanently  invested  in  the  fixed  capital  but  only 
temporarily  so,  pending  the  time  when  it  will  be  used  to  pur- 
chase replacing  property;  in  the  meantime  it  may  not,  of 
course,  be  capitalized. 

The  statute  quoted  above  expressly  prohibits  the  Commis- 
sion from  giving  its  consent  to  the  issue  of  stocks,  bonds,  etc., 
for  the  reimbursement  of  moneys  expended  from  income 
for  the  maintenance  of  service  and  replacements.  The  Com- 
mission is  placed  under  the  responsibility  of  ascertaining 
definitely  that  expenditures  for  such  purposes  are  not  in- 
cluded in  the  total  amount  for  which  income  shall  be  reim- 
bursed, but  even  with  the  most  careful  scrutiny  and  investi- 
gation there  will  be  cases  where  neither  the  company  nor  the 
Commission  will  be  able  to  demonstrate  conclusively  that  no 


CAPITALIZATION    FOR    SUNDRY    PURPOSES 


431 


part  of  the  moneys  were  expended  for  replacement.  The 
statute  will  be  satisfied  if  from  all  the  facts  it  appears  that  the 
moneys  were  expended  for  proper  purposes.  Even  in  cases 
where  the  authorization  relates  to  expenditures  still  to  be 
made,  it  sometimes  becomes  difficult  to  determine  that  all  of 
the  capital  to  be  acquired  thereby  will  represent  additions  to, 
or  betterments  of,  capital  and  not  replacements  in  any  part. 
Take  the  application  of  a  railroad  company  for  authority  to 
issue  stocks  and  bonds  for  the  acquisition  of  large  numbers 
of  cars.  How  can  it  be  determined  that  all  of  these  cars 
will  be  additions  and  not  replacements  of  capital?  So  far  as 
the  present  records  are  concerned,  there  may  be  no  evidence 
that  any  of  them  are  to  be  acquired  in  replacement,  but  if 
there  have  been  cars  re.tired  in  previous  years  and  new  ones 
installed  which  were  purchased  out  of  the  proce"eds  of  stocks 
and  bonds,  should  it  be  considered  that  those  cars  were  in 
replacement  of  those  retire'd,  or  should  it  be  said  that  the 
cars  about  to  be  acquired  will  be  in  part  replacement  of  those 
retired  in  past  years?  The  facts  become  very  difficult  to 
obtain  under  these  circumstances.  Or  again,  if  there  is  no 
indication  that  the  new  equipment  will  be  in  replacement,  in 
whole  or  in  part,  suppose  there  are  large  numbers  of  cars 
which  will  be  retired  in  succeeding  years ;  then  the  new  equip- 
ment acquired  gives  the  company  a  surplusage  of  capacity 
so  that  when  the  old  cars  are  retired  no  others  will  be  pur- 
chased to  replace  them.  Later  on,  it  may  appear  clearly  that 
some  of  the  new  equipment  was  actually  used  for  replace- 
ment. The  possibility  of  such  a  situation  developing  in  the 
future  may  be  a  proper  consideration  but  it  could  not  be  suffi- 
cient reason  for  withholding  authority  for  the  acquisition  of 
the  new  equipment,  especially  in  view  of  the  fact  that  it  will 
be  impossible  to  foretell  whether  such  equipment  will  give  a 
surplusage  of  capacity  or  not,  since  that  will  depend  wholly 
upon  the  fluctuations  in  volume  of  traffic.  If  guarding 
against  the  application  of  proceeds  of  capitalization  to  re- 


432 


CAPITALIZATION 


placements  of  capital  is  such  a  difficult  problem  in  relation  to 
expenditures  still  to  be  made,  it  becomes  more  difficult  when 
arising  in  connection  with  expenditures  which  have  been  made 
some  years  before. 

One  aspect  of  the  prohibition  against  reimbursing  income 
for  expenditures  on  replacements  or  for  maintenance  of  ser- 
vice is  its  application  to  depreciation.  This  matter  is  very  often 
overlooked,  or  else  it  is  imperfectly  understood.  Suppose  it  is 
sought  to  reimburse  income  for  the  cost  of  e\^uipment  pur- 
chased three  years  ago  at  $100,000.  In  the  operations  for 
three  years  a  part  of  its  service-life  has  expired,  and .  the 
earnings  of  the  company  have  returned  or  should  have  re- 
turned to  it  a  proportionate  part  of  the  cost.  If  accounting 
has  been  adequate,  this  proportion  of  cost  will  have  been  set 
aside  as  a  depreciation  reserve  out  of  charges  against  the  cur- 
rent operating  expenses,  which  charges  become  part  of  the 
cost  of  maintenance,  and  a  reserve  for  replacement,  so  that 
income  may  not  beiater  reimbursed  therefor.  This  will  hold 
true,  undoubtedly,  even  if  the  accounting  has  not  taken  care 
of  the  depreciation. 

The  terms  of  the  New  York  State  law  permit  an  authori- 
zation to  reimburse  the  treasury  "in  cases  where  the  applicant 
shall  have  kept  its  accounts  and  vouchers  of  such  expendi- 
tures in  such  manner  as  to  enable  the  Commission  to  ascertain 
the  amount  of  moneys  so  expended  and  the  purposes  for 
which  such  expenditure  was  made."  The  Commission  has 
not  construed  this  part  of  the  statute  to  be  mandatory  in  its 
requirement  that  the  determination  of  the  amount  be  based 
upon  vouchers  and  other  regular  records,  but  has  used  any 
method  of  examination  capable  of  displaying  the  facts, 
especially  where  expenditures  involved  antedated  the  pro- 
mulgation of  the  accounting  classification ;  expenditures  made 
since  then  and  in  accordance  with  the  classification  can  easily 
be  identified  in  the  manner  described  by  the  statute.  To 
avoid  dispute,   some  corporations  expending  large  amounts 


CAPITALIZATION   FOR   SUNDRY    PURPOSES 


433 


currently  on  capital  projects  and  which  they  will  later  want 
to  capitalize,  have  their  accounts  checked  periodically  by  en- 
gineers or  accountants  for  the  Commission. 

§  207.  (4)  Appraisals  to  Supplement  or  Check  Accounting 
Analyses 

If  the  accounting  method  will  not  determine  satisfactorily 
the  amount  of  capital  expenditures  paid  out  of  income,  nor 
permit  segregation  of  those  representing  replacements  from 
those  representing  additions  to,  or  betterments  of,  capital,  an 
approximation  by  an  appraisal  of  the  whole  property  can  be 
made.  The  total  money  amo'unt  developed  by  that  appraisal, 
increased  by  the  other  assets  on  hand,  will  be  compared  with 
the  outstanding  liabilities;  the  excess  of  the  assets  over  the 
liabilities  will  then  represent  the  earnings  retained  in  the  enter- 
prise against  which  stock  or  bonds  may  then  be  issued. 

The  term  "money  amount"  of  the  appraisal  is  used  here 
because  of  the  ambiguity  of  other  terms;  "value"  or  "cost" 
are  the  terms  most  often  employed,  but  those  who  use  them 
would  be  utterly  at  a  loss  to  give  a  satisfactory  definition  of 
"value,"  while  "ccTst"  may  be  original  cost  to  the  stockholders, 
or  the  amount  which  some  investigator  assumes  should  have 
been  the  cost  to  the  corporation  if  it  had  not  done  certain 
things  which  it  did  do,  or  had  done  certain  things  which  it 
did  not  do ;  or  again,  it  may  be  "reproduction  cost,"  which  is 
neither  cost  nor  value,  nor  even  what  it  purports  to  be — the 
cost  to  reproduce — since  the  facts  which  might  obtain  as  to 
reproduction  are  purely  speculative. 

It  is  worth  while  to  digress  for  a  moment  and  to  con- 
sider the  ambiguity  of  terms,  or  the  misapprehension  con- 
cerning the  nature  of  valuations  and  appraisals  of  public 
utility  properties.  Valuations  are  much  talked  of  in  these 
days.  The  Interstate  Commerce  Commission  is  now  engaged 
in  the  task  of  appraising  railroad  properties  throughout  the 
country — a  project  which  will  cost  the  government  and  the 


434  CAPITALIZATION 

railroads  at  least  $100,000,000  if  it  is  carried  to  completion. 
Certain  states  have  appraised  or  are  appraising  all  public 
utility  properties  within  their  jurisdiction.  Such  appraisals 
can  be  the  means  of  great  benefit  to  both  the  public  and  the 
corporations,  but  the  real  nature  of  the  findings  must  be  so 
stated  as  to  cause  no  misapprehension.  -In  none  of  these 
appraisals  is  a  finding  of  real  "value"  involved ;  a  finding  of 
value  would,  of  course,  be  a  finding  of  one  single  existing 
fact  capable  of  demonstration  and  proof;  it  would  affect  the 
accounts,  rates,  taxes,  etc.,  and  would  in  turn  be  affected  by 
them,  but  it  would  still  remain  a  single  fact  the  nature  of 
which  would  be  understood  alike  by  all  who  dealt  with  it. 
There  cannot,  therefore,  be  one  value  for  rate-making  pur- 
poses, another  for  accounting  and  capitalization,  another  for 
the  purposes  of  public  purchase,  etc.  The  use  of  such 
phrases  conveys  a  wrong  impression ;  one  may  be  careful  to 
specify  "value  for  rate-making  purposes,"  but  another  will 
forget  the  qualification  and  remember  "value"  alone. 

It  is  unfortunate  that  very  often  a  wrong  impression  is 
intentionally  conveyed;  for  instance,  reproduction  cost  placed 
at  a  figure  to  be  used  for  a  special  purpose  is  compared  with 
the  par  value  of  stocks  and  bonds  outstanding  for  the  sake  of 
arousing  or  fostering  prejudice  against  the  company.  Some- 
times the  improper  comparison  is  due  simply  to  carelessness 
or  ignorance.  The  reproduction  cost  of  a  certain  railroad  re- 
ported recently  by  the  Interstate  Commerce  Commission  was 
compared  widely  with  the  company's  capitalization.  The 
comparison  showed  a  very  great  excess  of  the  capitalization 
over  the  reproduction  cost  and  in  many  quarters  this  dis- 
crepancy was  taken  up  as  conclusive  proof  of  "water"  in  rail- 
road capitalization.  The  fact  of  the  matter  was  that  this 
company's  investments  in  securities  of  controlled  companies 
were  far  more  important  than  the  investment  in  road  and 
equipment,  and  the  greater  proportion  of  its  stocks  and  bonds 
had  been  issued  to  finance  the  investments  in  securities.    The 


CAPITALIZATION    FOR    SUNDRY    PURPOSES 


435 


Commission's  finding  of  reproduction  cost  related,  of  course, 
only  to  the  road  and  equipment. 

This  is  a  good  illustration  of  the  dangers  involved  in  the 
careless  use  of  the  results  of  appraisals.  Hundreds  of  thou- 
sands of  investors  in  railroad  securities  are  awaiting  the  find- 
ings of  the  Interstate  Commerce  Commission  in  its  work  of 
appraisal,  supposing  that  the  Commission  is  trying  to  "investi- 
gate, ascertain,  and  report  the  value  of  all  the  property  owned 
or  used  by  every  common  carrier,"  as  the  law  requires  it  to  do, 
while  actually  it  is  not  engaged  in  finding  value,  but  in  de- 
veloping a  highly  speculative  reproduction  cost  of  doubtful 
value.  The  work  of  the  Commission  cannot  be  commended 
or  condemned,  however,  upon  the  results  so  far  accomplished ; 
there  is  little  doubt  that  as  it  proceeds  with  its  work  and  the 
facts  as  to  the  manner  in  which  its  work  is  being  conducted 
and  the  results  sought  to  be  produced  become  known,  radical 
changes  will  need  to  be  made,  so  that  eventually  something 
really  worth  while  may  be  achieved  through  its  efforts. 

These  valuations  conducted  by  the  Interstate  Commerce 
Commission  and  other  state  commissions  will  have  no  direct 
bearing  upon  problems  of  capitalization  (except  indirectly 
through  their  influence  on  rates  and  earnings)  unless  they 
are  required  to  be  made  the  basis  for  revision  of  capital  ac- 
counts. In  Chapter  XVI  was  quoted  a  plea  of  the  Interstate 
Commerce  Commission, that  a  physical  valuation  of  railroads 
would  facilitate  a  correction  of  their  accounts  and  balance 
sheets,  but  there  can  be  no  question  that  the  Commission 
would  now  be  the  first  to  protest  against  such  a  procedure, 
and  the  last  to  admit  the  propriety  of  these  valuations  as  a 
basis  for  accounting.  Where  a  valuation  is  made  in  the 
course  of  a  capitalization  case,  however,  the  accounting  will 
almost  always  be  required  to  conform  to  the  results  of  the 
valuation;  the  extent  to  which  the  New  York  Public  Service 
Commission  of  the  Second  District  follows  this  practice  has 
already  been  described  in  §  169. 


436  CAPITALIZATION 

An  appraisal  which  seeks  to  determine  the  amount  prop- 
erly allowable  in  capitalization  to  reimburse  the  treasury  for 
capital  expenditures  made  out  of  earnings  must  be  limited  to 
investigation  of  what  the  property  on  hand  cost  the  corpora- 
tion and  which  it  would  have  been,  under  the  then  existing 
practices,  entitled  to  pay  out  of  the  proceeds  of  stock  or  bond 
issues.  It  is  a  mistake  to  base  a  determination  as  to  this 
matter  upon  a  statement  of  "reproduction  cost" ;  such  a  state- 
ment may  warrant  an  issue  of  stocks  and  bonds  on  other 
grounds,  but  not  for  the  specific  purpose  of  reimbursing  the 
corporate  treasury  for  capital  expenditures  made  out  of  earn- 
ings. A  modification  of  this  method  is  necessary  where  only 
expenditures  during  a  given  number  of  years,  e.g.,  five  years 
described  in  the  New  York  law,  are  sought.  The  amount  of 
stock  or  bonds  which  may  be  issued  is  necessarily  limited  to 
that  which  will  realize  an  amount  corresponding  to  the  actual 
expenditures  made  by  that  corporation,  reimbursing  its  treas- 
ury for  the  amount  of  the  actual  outlay.  The  amount  of 
added  capitalization  will  thus  bear  no  relation  to  the  value  of 
the  additions  and  betterments  of  plant,  but  only  to  the  cost 
they  involved. 

Public  utilities  are  no  longer  given  the  right  of  estimating 
the  enhanced  value  of  their  assets  for  the  purposes  of  issuing 
securities  against  such  enhanced  values  either  to  be  distributed 
as  dividends  or  used  for  other  purposes.  If  the  utility  wants 
to  dispose  of  any  part  of  its  assets  it  may,  of  course,  do  so 
(subject  to  such  duty  as  it  may  owe  the  public  to  provide  for 
continuance  of  operations)  and  may  seek  to  realize  just  as 
much  as  it  possibly  can,  and  the  excess  of  the  consideration 
received  over  the  cost  of  that  asset  to  it  will  represent  a  profit 
which  it  may  use  any  way  it  sees  fit.  But  so  long  as  it  holds 
the  properties  and  is  using  them,  it  cannot  anticipate  a  profit 
from  a  supposititious  sale  which  may  never  take  place.  True 
enough,  this  seems  somewhat  inequitable;  the  stockholders 
during  a  certain  period  may  have  used  their  earnings  to  build 


CAPITALIZATION   FOR   SUNDRY   PURPOSES  437 

up  the  property  and  may  otherwise  have  so  managed  the 
utility  that  it  acquires  a  high  value  no  part  of  which  they 
can  realize  (except  in  an  incidental  way  through  better  divi- 
dends) ;  they  may  thereafter  retire  from  ownership  and  others 
who  have  succeeded  them  may  find  it  possible  to  dispose  of 
some  of  those  assets.  For  instance,  if  the  original  location 
of  an  electric  plant  has  since  become  valuable  because  of  the 
growth  of  the  community,  the  company  may  find  it  profitable 
to  change  the  location  of  the  plant  and  sell  the  old  site  at 
such  a  price  that  over  and  above  the  original  cost  and  the 
expenses  of  relocation  there  will  still  remain  a  profit  immedi- 
ately available  for  distribution.  The  situation  is  not  as  bad 
as  it  seems,  for  if  stockholders  exercise  proper  care  in  the 
study  of  investment  values  they  will  be  able  to  estimate  the 
value  of  the  equity  behind  their  stock  certificates,  and  the 
market  will  be  willing  to  allow  that  value  in  full. 

§  208.  (5)  Reimbursement  of  Proper  Expenditures  a  Matter 
of  Right 
If  the  expenditures  for  which  income  is  to  be  reimbursed 
were  for  a  proper  purpose  and  the  amounts  spent  were  in  good 
faith  and  have  been  recorded  according  to  the  established 
classification  of  accounts,  the  total  actual  amounts  so  expended 
may  be  capitalized,  other  measures  of  value  notwithstanding, 
except  that  depreciation  not  fully  provided  for  in  the  accounts 
may  undoubtedly  be  deducted  from  the  actual  cost.  The  Ne- 
braska Commission  authorized  capitalization  of  actual  expendi- 
tures amounting  to  $129,307.81  for  certain  properties  upon 
which  the  Commission's  engineer  had  placed  a  reproduction 
value  of  $107,686.  The  applicant  accounted  for  the  excess  of 
cost  by  explaining  that  the  work  had  been  conducted  during 
winter  months  in  the  attempt  to  hurry  construction  and  make 
the  project  revenue-earning  at  an  early  date,  rather  than 
to  delay  the  project  for  the  sake  of  a  somewhat  lower  cost  at 
the  expense  of  loss  in  revenue  and  the  possible  occupation  of 


438  CAPITALIZATION 

the  territory  by  a  competing  corporation;  the  entire  cost  was 
allowed  by  the  Commission  pursuant  to  the  finding  that  it  was 
"reasonably  required  for  the  purpose  for  which  it  was  ex- 
pended." ' 

The  Indiana  Commission  allowed  a  capitalization  of  but 
$75,000  out  of  $103,000  bonds  applied  for  by  an  applicant 
to  reimburse  the  treasury  for  expenditures  in  extension  and 
improvements;  authority  for  the  remaining  $28,000  was  re- 
fused because  of  the  Commission's  opinion  that  the  improve- 
ments represented  thereby  "will  be  neither  used  nor  useful  for 
the  convenience  of  the  public,  for  the  reason  that  such  prop- 
erty is  a  duplication  of  instrumentalities  already  in  existence 
and  in  use,"  owned  by  another  company  sharing  the  territory, 
"and  amply  sufficient  to  supply  all  the  needs  of  the  commu- 
nity, where  such  property  for  which  the  treasury  is  to  be 
reimbursed  in  the  sum  of  $28,000  is  erected  and  constructed." 
The  Supreme  Court  of  that  state  overruled  the  Commission, 
however,  holding  that  if  the  company  proved  the  facts  as  to 
the  expenditure,  it  was  entitled  to  an  order  for  the  issue  of 
securities.* 

It  very  often  happens  that  when  a  corporation  comes  up 
for  authorization  to  issue  stocks  or  bonds  for  the  reimburse- 
ment of  income,  it  adds  a  number  of  items  to  the  list  of 
actual  expenditures  already  charged  to  capital;  it  may,  for 
instance,  ask  an  allowance  for  interest  during  construction, 
for  miscellaneous  expenses,  etc.  The  inclusion  of  such  items 
is  within  the  discretion  of  the  commission;  it  is  doubtful  if 
such  allowances  can  be  made,  although  special  considerations 
may  be  found  fully  to  warrant  their  inclusion. 

§  209.     Capitalization   for   Improvement   or   Maintenance   of 
Service 

The  New  York  Public  Service  Commissions  Law  author- 


•   In  re  Omaha  and  Lincoln  Ry.  &  Lt.  Co.,  P.  U.  R.  1916-8,  564. 
♦Public   Service  Commission   v.    State  ex  rel.   Merchants  H.   &  L.   Co.,   184  Ind. 
Rep.  273. 


CAPITALIZATION   FOR   SUNDRY    PURPOSES 


439 


izes  the  issue  of  stocks  and  bonds  of  a  public  service  corpora- 
tion when  necessary  "for  the  improvement  or  maintenance  of 
its  service." 

The  expenditures  here  contemplated  have  nothing  to  do 
with  the  acquisition  of  property  of  any  kind;  they  are  simply 
costs  of  service,  that  is,  operating  expenses.  "Capitalization 
for  operating  expenses  is  in  general  grossly  offensive,  yet  the 
statute  apparently  confers  upon  the  Commission  power  to 
permit  it." 

A  newly  organized  enterprise  is  allowed  working  capital 
out  of  the  proceeds  of  stock  and  bond  issues  to  an  amount 
sufficient  to  defray  the  costs  of  service  until  service  produces 
its  own  revenue ;  from  that  point  on,  service  ought  to  perpetu- 
ate itself,  and  the  revenue  should  be  sufficient  to  pay  the  costs 
of  service.  Circumstances  may  at  some  time  develop,  how- 
ever, which  will  make  it  impossible  for  the  corporation  to  pay 
operating  expenses  out  of  the  current  income.  If  no  other 
expedient  were  then  available,  the  enterprise  would  break 
down — an  eventuality  which  must  be  avoided  in  the  case  of  a 
public  service.  The  causes  producing  that  situation  must  then 
control  the  remedy  which  must  be  either  reorganization  or 
the  advance  of  a  second  instalment  of  working  capital,  as  it 
were.  Reorganization  will  be  resorted  to  if  there  is  a  funda- 
mental defect  in  organization  or  management,  or  else  if  the 
accumulated  financial  burdens  make  such  demands  upon  income 
that  it  is  clearly  impossible  to  make  the  ends  meet.  A  second 
instalment  of  working  capital  may  be  properly  advanced,  and 
that  is  the  authorization  of  the  statute,  where  the  inability  is 
temporary  and  there  exist  no  fundamental  causes  which  can- 
not be  cured.  Since  this  is  a  temporary  condition,  it  will  be 
expected  that  the  moneys  procured  out  of  capitalization  and 
used  for  operating  expenses  will  be  returned  very  soon  to  the 
assets  of  the  company  in  the  form  of  some  property,  rights, 
or  claims  acquired  through  the  use  of  subsequent  income;  in 
precisely  the  same  way  that  original  working  capital,  while 


440 


CAPITALIZATION 


first  used  to  pay  costs  of  service,  will  later  be  found  among 
the  corporate  assets  in  the  form  of  property,  rights,  or  claims. 

The  expedient  must  be  used  with  the  greatest  caution. 
The  existence  of  a  situation  requiring  its  use  need  not  neces- 
sarily indicate  or  result  in  impaired  credit,  but  it  may  and 
will  often  do  so,  so  that  the  costs  of  obtaining  the  moneys 
desired,  i.e.,  the  interest  to  be  paid  or  discount  to  be  suffered, 
will  present  perplexing  problems,  the  determination  of  which 
will  depend  upon  the  degree  of  the  existing  exigency. 

If  accruing  operating  expenses  may  be  met  out  of  the  pro- 
ceeds of  capitalization,  may  accrued  operating  deficits  be  met 
in  the  same  way?  Both  situations  represent  the  insufficiency 
of  income  for  the  costs  of  service.  In  the  matter  of  capital- 
ization, however,  this  difference  exists:  in  the  case  of  defray- 
ing present  expenses  out  of  the  proceeds  of  stock  and  bond 
issues,  the  aid  rendered  is  assumed  to  be  temporary  and  future 
income  must  make  the  advance  good ;  in  other  words,  the  real 
remedy  for  the  present  inability  comes  from  the  revenue  of 
the  service  the  rendition  of  which  is  made  possible  by  the  help 
rendered.  In  the  case  of  capitalizing  accrued  deficits,  there  is 
an  admission  that  income  cannot  make  good  the  deficiency, 
and  the  situation  which  has  been  existing  is  to  be  remedied 
from  the  proceeds  of  stocks  and  bonds  and  not  from  income, 
while  income  will  thereafter  have  to  meet  the  added  burden  of 
the  increased  capitalization. 

Attempts  to  make  good  accumulated  deficits  out  of  the 
proceeds  of  stock  or  bond  issues  have  been  quite  frequent. 
Where  these  deficits  represent  operations  during  the  period 
of  developing  the  enterprise,  they  are  in  many  jurisdictions 
recognized  as  proper  subjects  of  capitalization,  although  they 
are  usually  designated  by  some  other  name,  such  as  "develop- 
ment expenses."  Even  here,  however,  the  item  is  or  should  be 
very  carefully  scrutinized ;  the  mere  fact  that  it  covers  a  period 
immediately  following  the  commencement  of  operations  is  not 
sufficient  to  warrant  its  capitalization,  for  the  venture  may 


CAPITALIZATION    FOR    SUNDRY    PURPOSES  441 

have  been  foolhardy  or  improperly  conducted;  for  instance, 
the  company  may  have  sought  to  operate  in  a  territory  which 
was  already  adequately  supplied.  On  the  other  hand,  a  rail- 
road company  may  start  operating  its  completed  portions  of 
road  as  soon  as  possible,  wholly  at  a  loss,  since  its  full  traffic 
is  unavailable,  and  the  losses  will  be  properly  subject  to  capi- 
talization. In  this  last  instance  operations  at  a  loss  have 
reduced  other  expenses  which  could  have  been  capitalized. 

The  capitalization  of  operating  deficits  may  sometimes  be 
attempted  by  indirection.  There  came  before  the  New  York 
Public  Service  Commission,  Second  District,  an  application 
for.  authorization  to  issue  $6,000,000  of  ten-year,  4  per  cent 
debenture  bonds  to  discharge  debts  of  approximately  that 
amount  due.  There  was  no  question  that  a  valid  indebtedness 
existed,  the  creditor  being  a  controlling  corporation;  but  it 
also  appeared  that  the  operations  of  the  applicant  had  been 
conducted  at  a  loss  for  some  years  and  the  Commission  con- 
cluded that  the  dejficit  was  represented  by  the  indebtedness 
sought  to  be  funded,  since  there  was  nothing  else  on  the  bal- 
ance sheet  to  which  it  could  properly  be  assigned.  It  accord- 
ingly held  that  "of  the  existing  indebtedness  of  $6,062,956  as 
it  stood  on  December  31,  1908,  the  sum  of  $1,666,452  should 
not  be  treated  as  subject  of  capitalization." 

This  deficit,  said  the  Commission,  "should  be  paid  out  of 
the  first  net  income  arising  from  operation,  and  no  action 
should  be  taken  by  this  Commission  which  can  in  the  future 
be  construed  as  warranting  the  conclusion  that  it  authorized 
directly  or  indirectly  the  capitalization  of  an  operating  deficit. 
Such  a  deficit  must  unquestionably  be  carried  along  in  some 
appropriate  form  as  an  existing  indebtedness.  If  it  is  once 
evidenced  by  long-term  securities  it  will  most  likely  be  treated 
as  a  funded  indebtedness  to  remain  as  a  permanent  charge 
upon  the  revenues  of  the  company.  When  this  company  has 
been  established  upon  a  paying  basis,  a  condition  which  it  is 
confidently  expected  by  the  management  will  soon  be  reached. 


442 


CAPITALIZATION 


the  tentative  proposition  is  to  convert  the  securities  represent- 
ing this  deficit  into  common  stock  entitled  to  a  dividend.  This 
avowed  intention  of  the  applicant  raises  the  question,  what  is 
the  proper  disposition  of  a  temporary  operating  deficit?  If  it 
is  to  be  borne  by  stockholders,  the  method  of  treatment  is  to 
carry  it  along  upon  short-time  paper  until  the  net  income  is 
adequate  for  its  payment.  If  money  for  its  liquidation  is  se- 
cured by  the  sale  of  stock  or  bonds  which  entail  a  fixed  annual 
charge  upon  the  revenues  of  the  corporation,  the  dividends 
upon  the  stock  or  the  interest  upon  the  bonds  become  a  charge 
upon  the  public  in  the  rates  which  must  be  fixed  so  as  to  pro- 
duce the  sums  requisite  for  such  purpose,  and  the  burden  of 

the  loss  is  thus  placed  upon  the  public ^ 

"It  is  true  that  if  debentures  are  issued  for  the  amount  of 
this  deficit  running  for  a  term  of  ten  years,  and  they  are  then 
paid  from  the  net  income  of  the  company,  the  result  would 
be  the  same  as  if  one  year  notes  were  issued  and  renewed 
annually  for  the  same  period,  assuming  of  course  the  same 
rate  of  interest.  The  difference  between  the  two  methods  lies 
in  two  features:  First,  the  deficit  should  be  paid  from  the 
first  available  income  although  dividends  may  thereby  be  de- 
ferred ;  second,  the  ten-year  debentures  will  at  once  be  treated 
as  funded  indebtedness  in  accounts  of  the  company  and  most 
likely  will  continue  in  that  class  for  all  time  or  be  converted 
into  stock,  which  amounts  to  the  same  thing,"  ^ 

§  210.  Capitalization  for  the  Discharge  or  Refunding  of  Ob- 
ligations— (i)  Funding  Operations 
Funding  and  refunding  operations  must  be  carried  out 
under  the  authorization  of  the  statute  for  issues  of  stocks, 
bonds,  and  other  evidences  of  indebtedness,  "for  the  discharge 
or  refunding  of  its  obligations."  The  word  "obligations" 
must  necessarily  be  understood  to  refer  only  to  money  obliga- 
tions.    These  obligations  may  consist  of  floating  debt  or  of 

"Matter  of  Long  Island  R.  R.  Co.,  2  P.  S.  C.  Rep.   (2nd  D..  N.  Y.)  275   (280). 
"  Id.,  page  282. 


CAPITALIZATION    FOR    SUNDRY    PURPOSES  443 

funded  debt.  The  capitalization  of  the  former  class  of  obli- 
gations constitutes  funding  operations,  and  that  of  the  latter 
class,  refunding  operations. 

The  floating  debt  of  a  public  service  corporation  consists 
of  ol)ligations  to  repay  sums  borrowed,  or  to  pay  for  supplies 
purchased,  services  received,  interest  on  funded  debt,  etc. 
Moneys  borrowed  will  ordinarily  be  represented  by  promis- 
sory notes,  while  other  obligations  will  appear  in  open  book 
accounts. 

The  issue  of  notes  for  moneys  borrowed  temporarily  and 
for  a  period  not  extending  beyond  one  year  from  date  of  issue 
is  uniformly  allowed  without  prior  authority  of  a  commission. 
This  permission  is  intended  to  facilitate  the  transaction  of 
ordinary  business  in  the  course  of  which  purely  temporary 
liabilities  would  naturally  be  incurred  or  loans  contracted 
which  are  intended  to  be  discharged  upon  maturity.  The 
projection  of  commission  regulation  into  every  such  routine 
transaction  of  a  corporation  would  be  irritating  and  even 
harmful. 

The  permission  is  capable,  however,  of  being  used  for 
more  ambitious  purposes  and  very  often  as  a  step  in  perma- 
nent financing.  There  have  been  many  instances  where  one- 
year  notes  have  been  issued  in  amounts  so  large  that  their 
discharge  upon  maturity  was  clearly  not  contemplated,  or  else 
they  were  issued  for  the  purpose  of  acquiring  additions  to, 
or  betterments  of,  capital  which  would  undoubtedly  be  sought 
later  to  be  capitalized.  It  is  clear  that  in  these  cases  the  in- 
debtedness itself  will  outlast  the  period  of  one  year,  although 
its  indicia  may  not ;  it  is  palpably  evident  that  in  these  instances 
the  corporations  are  attempting  to  evade  the  law,  and  to  do 
by  indirection  that  which  they  are  not  permitted  to  do  directly. 
The  law  deals  with  the  substance  of  things  and  not  the  form. 
One  purpose  of  public  service  commission  laws  is  to  regulate 
capitalization,  and  the  intent  is  to  regulate  capitalization  at 
every  phase  thereof.     The  technical  right  of  the  corporation 


444  CAPITALIZATION 

to  issue  one-year  notes  should  therefore  not  be  abused.  It 
would  be  better  if  the  statutes  could  be  so  framed  as  to  allow 
the  exemption  only  in  cases  where  the  indebtedness  itself  is 
purely  temporary  and  for  routine  purposes,  but  even  while 
the  statutes  remain  as  they  now  are,  corporations  subject 
thereto  will  do  well  to  observe  the  spirit  of  the  law  rather 
than  seek  advantage  of  a  technicality.  After  all,  the  Golden 
Rule  can  be  made  as  important  a  factor  in  relations  between 
corporations  and  commissions  as  in  other  human  relationships. 

It  is  unfortunate  that  the  use  of  the  exemption  for  the 
purpose  of  evading  the  statute  has  sometimes  been  due  to  the 
shortcomings  of  the  regulating  commissions  themselves;  they 
have  often  failed  to  act  quickly  where  quick  action  was  neces- 
sary, so  that  the  corporation  has  been  forced  to  resort  to  the 
expedient  afforded  by  this  exemption.  Moreover,  there  was 
noted  in  these  pages  an  instance  where  the  conflicting  decisions 
of  the  commissions  of  two  states  upon  an  application  for  the 
issue  of  two-year  notes  left  no  alternative  but  for  the  appli- 
cant to  take  the  entire  project  out  of  the  jurisdiction  of  both 
commissions  by  substituting  one-year  notes  and  issuing  them 
without  the  authority  of  either  commission. 

Abuse  of  this  exemption  of  the  statute  can  be  controlled 
if  limitations  are  placed  upon  the  repeated  renewals  of  -the 
notes,  as  has  already  been  done  in  the  laws  of  some  states. 
In  general  it  is  safe  enough  to  rely  upon  the  established  bank- 
ing and  commercial  usages  to  prevent  any  abuse  through  fre- 
quent manipulation  of  this  device ;  there  will  be  many  instances, 
however,  where  the  lender  is  a  controlling  or  afflliated  cor- 
poration which  is  willing  to  have  the  loan  stand  for  a  long 
term  of  years,  the  yearly  renewals  being  wholly  perfunctory. 
This  controlling  corporation  may  itself  be  located  in  another 
state  and  by  issuing  its  certificates  of  indebtedness  in  its  own 
state  where  there  may  be  no  regulation,  or  not  as  strict  regu- 
lation as  in  the  state  where  the  subsidiary  corporation  is  domi- 
ciled, it  may  for  many  years  finance  its  subsidiary  corporation 


CAPITALIZATION   FOR   SUNDRY    PURPOSES  445 

which  wants  to  evade  the  strict  laws  of  the  state  in  which  it 
is  situated. 

Eventually,  of  course,  indebtedness  incurred  in  any  of  the 
above  methods  will  require  funding,  and  the  approval  of  the 
commission  will  be  sought.  The  whole  question  of  the  pur- 
poses for  which  the  moneys  were  borrowed,  the  reasonable- 
ness of  the  amounts  borrowed,  and  all  of  the  many  considera- 
tions involved  will  need  to  be  considered  in  retrospect;  the 
application  of  the  moneys  derived  will  then  date  back  so  far 
in  the  past  and  have  become  so  intermingled  with  expenditures 
from  authorized  capitalization  or  from  income  or  surplus 
funds,  that  the  determination  whether  the  moneys  so  ex- 
pended were  for  value  and  for  purposes  described  in  the  law 
may  become  very  difficult. 

The  general  rule  is  that  the  authorization  of  the  statute 
may  be  invoked  only  when  the  proceeds  of  the  indebtedness 
to  be  funded  had  been  applied  to  purposes  described  in  the 
law  as  proper  to  warrant  the  issue  of  stocks  and  bonds  in  the 
first  instance.  Thus,  the  mere  fact  that  there  appears  a  present 
liability  for  supplies  to  be  used  in  production  cannot  warrant 
payment  being  made  out  of  the  proceeds  of  stocks  or  bonds 
where  the  supplies  have  since  been  used  up  and  their  cost 
charged  to  the  operating  expenses;  neither  would  the  produc- 
tion of  a  promissory  note  entitle  the  maker  to  authorization 
for  its  funding  where  the  moneys  were  borrowed  for  a  pur- 
pose which  would  not  have  been  permitted  upon  an  application 
for  direct  capitalization. 

"Where  ....  notes  covering  the  acquisition  of  property 
are  sought  to  be  refunded  by  a  bond  issue,  determination  of 
the  question  whether  the  capital  to  be  secured  by  such  issue 
is  'reasonably  required'  involves  inquiry  as  to  the  character 
and  use  of  the  property  with  reference  to  the  general  business 
and  public  duties  of  the  applying  corporation."  ^  "It  is  ap- 
parent that  obligations  may  be  issued  for  other  than  proper 

T  Matter  of  Delaware  &  Hudson  Co.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  243  (376). 


446 


CAPITALIZATION 


corporate  purposes  and  also  for  purposes  which  are  not  the 
proper  subjects  of  capitalization.  The  mere  fact  that  obliga- 
tions exist  is  not  of  itself  sufficient  to  justify  their  capitaliza- 
tion. The  purpose  for  which  the  indebtedness  was  incurred, 
or,  to  express  the  idea  with  greater  exactness,  the  uses  made 
of  the  funds  or  property  acquired  or  services  rendered  as  the 
consideration  of  such  obligations,  are  material  subjects  of 
inquiry.  .  .  .  The  same  discriminating  scrutiny  should  and 
will  be  extended  to  indebtedness  as  to  other  subjects  enum- 
erated in  that  statute."  ^ 

The  funding  of  bond  interest  is  a  very  unusual  expedient, 
yet  it  has  been  allowed  in  at  least  one  case ;  there  were  in  that 
case,  however,  attending  circumstances  which  place  it  in  a 
class  by  itself  and  destroy  its  usefulness  as  a  precedent.  At 
the  close  of  1908  the  Erie  Railroad  Company  was  described 
as  facing  a  difficult  situation.  It  was  still  suffering  from  the 
depression  following  the  panic  of  1907,  and  was  also  trying 
to  recover  from  a  most  disastrous  and  prolonged  strike  of 
employees  in  its  mechanical  department;  it  had  theretofore 
undertaken  extensive  improvements  for  the  completion  of 
which  more  than  $4,000,000  would  be  necessary  almost  imme- 
diately, while  other  important  and  necessary  improvements 
had  to  be  carried  out  wijthin  a  short  period ;  certain  equipment 
trust  obligations  were  maturing  annually,  and  an  outstanding 
issue  of  $10,500,000  short-term  notes  would  mature  within 
the  next  three  years.  To  relieve  the  situation  the  company 
early  in  1909  applied  to  the  Public  Service  Commission  for 
authority  to  issue  $30,000,000  5  per  cent  collateral  bonds 
maturing  in  not  exceeding  30  years,  to  be  used  in  refunding 
the  short-term  notes,  certain  equipment  trust  obligations,  etc., 
and  also  to  refund  semiannual  interest  coupons  to  fall  due 
during  the  next  five  years  upon  the  4  per  cent  convertible  and 
general  lien  bonds,  such  coupons  aggregating  $11,380,000  for 


»  Matter  of  Lehigh  &  Hudson  River  Ry.  Co.,  i  P.  S.  C.  Rep.   (2nd  D.  N.  Y.)  224 
(232). 


CAPITALIZATION    FOR    SUNDRY    PURPOSES  447 

the  period  of  five  years.  The  coupons  were  to  be  deposited 
with  the  trustee  named  in  the  collateral  trust  indenture,  as 
security  for  the  bonds  to  be  issued. 

The  company  proposed  to  fund  this  interest  temporarily 
by  exchanging  an  amount  of  the  proposed  collateral  bonds 
equal  in  face  value  to  the  amount  of  such  coupons,  namely, 
$11,380,000  par  value  of  bonds  for  a  like  amount  represented 
in  interest  coupons.  It  was  further  proposed,  however,  that 
both  the  collateral  trust  indenture  and  the  order  of  the  Public 
Service  Commission  should  stipulate  and  require  that  the 
company  expend  from  income  during  each  year  of  the  said  five 
years,  an  amount  upon  improvements  of  the  property  equal 
to  the  face  value  of  the  coupons  which  would  have  fallen  due 
semiannually;  i.e.,  the  company  would  be  relieved  of  the  pay- 
ment of  $2,276,000  in  interest  annually  and  would  expend  a 
like  sum  upon  improvements,  so  that  at  the  end  of  five  years 
the  bonds  so  exchanged  for  coupons  would  all  represent  capi- 
tal expended  for  improvements.  The  annual  interest  upon 
the  bonds  issued  to  refund  the  coupons  would  be  $569,000, 
which,  deducted  from  the  $2,276,000  of  interest  charges  thus 
avoided,  would  leave  net  earnings  of  $1,707,000,  annually  re- 
leased for  five  years  from  the  burden  of  interest  charges.  It 
is  almost  superfluous  to  add  that  no  dividends  were  to  be  paid 
during  this  five-year  period. 

The  Public  Service  Commission  allowed  the  requested  cap- 
italization for  this  purpose,  deciding  that  the  application  came 
"within  the  purposes  stated  in  the  law  for  which  new  or  addi- 
tional capital  may  be  permitted.  However  inadvisable  the 
course  might  be,  a  bond  issue  simply  to  fund  a  stated  amount 
of  interest  is  not  excluded  by  the  statute,  and  it  would  be  for 
the  Commission  to  determine  in  such  a  case,  as  in  every  case 
of  capitalization  sought,  whether  the  capital  to  be  secured  by 
the  proposed  issue  is,  under  all  circumstances,  including  those 
pertaining  to  the  issue  itself,  reasonably  required 

"In  this  case  having  ascertained  that  additional  capital  is 


448  CAPITALIZATION 

required,  we  must  still  determine  whether  in  view  of  the  com- 
pany's whole  situation,  financial,  physical  and  operating,  the 
securing  of  capital  indirectly  by  the  funding  and  temporary 
avoidance  of  interest  charges  is  a  reasonable  means  of  securing 
capital  for  the  company's  proper  corporate  purposes.  It  is  not 
to  be  denied  that  such  a  means  of  obtaining  funds  is  extraordi- 
nary. Nor  can  it  be  gainsaid  that  if  indulged  in  largely  by 
any  company,  without  in  some  way  putting  the  money  into 
the  property  and  increasing  thereby  its  earning  capacity,  the 
policy  must  lead  straight  to  financial  suicide.  On  the  other 
hand,  the  temporary  funding  of  interest  charges  during  a 
period  of  low  returns  from  operation  has  been  in  the  past 
resorted  to  by  carriers  as  it  has  been  by  individuals  when  in 
the  stress  of  financial  stringency  they  borrow  money  for  short 
periods  to  meet  interest  payments  upon  mortgaged  real  prop- 
erty. In  every  such  case  the  amount  of  interest  to  be  refunded, 
the  time  covered  by  the  extension,  the  resources  of  the  mort- 
gagor and  ability  and  methods  to  apply  such  resources  deter- 
mine the  question  of  safety  and  propriety.  Here  the  applicant 
is  seeking  approval  of  the  funding  of  five  years'  unaccrued 
interest  on  two  subordinate  mortgage  liens.  Without  attach- 
ment of  conditions  such  a  proposal  on  the  part  of  a  public 
service  corporation  should  be  summarily  rejected.  The  ap- 
plicant here,  however,  distinctly  meets  that  fundamental  ob- 
jection by  declaring  its  intention  during  the  five  years  to  put 
all  of  that  money  into  appropriate  and  required  improvements 
of  its  property  by  taking  an  equal  amount  from  its  net  income, 
according  as  the  due  dates  of  the  coupons  ensue,  and  it  shows 
that  its  ordinary  income  with  the  relief  afforded  by  the  re- 
funding of  such  interest  and  of  the  stated  note  obligations  will 
be  amply  sufficient  for  the  purpose.  It  is,  moreover,  willing 
that  this  shall  be  provided  for  in  the  collateral  indenture  cover- 
ing the  proposed  bond  issue  and  that  this  Commission  shall 
make  from  time  to  time  any  necessary  orders  in  the  premises. 
It  is  difficult  to  see  how  the  fundamental  objection  could  be 


CAPITALIZATION   FOR   SUNDRY   PURPOSES 


449 


met  more  fully.  Plainly  under  such  action  the  objection  does 
not  exist,  for  the  funding  ceases  to  be  funding  in  equal  amounts 
each  year  and  at  the  end  of  the  five-year  period  it  ceases 
altogether.  The  bonds  exchanged  for  coupons  become  as  that 
time  elapses  bond  capital  based  wholly  upon  increased  prop- 
erty value  and  stand  the  same  as  any  other  capital  issued  for 

that  purpose "  ^ 

This  decision  has  been  very  seriously  criticized;  undoubt- 
edly it  was  fully  within  the  law,  but  the  wisdom  of  the  expedi- 
ent used  is  open  to  argument.  It  is  doubtful  if  the  Commission 
itself  will  ever  use  it  as  a  precedent.  Subsequent  to  the  date 
of  this  decision  the  Commission  denied,  so  far  as  it  involved 
the  funding  of  interest  coupons  matured  and  unpaid  and  ag- 
gregating $403,283,  an  application  for  authority  to  issue  bonds 
for  the  purpose  of  retiring  certain  matured  bonds  with  coupons 
attached.  "No  sufficient  cause  has  been  shown  why  unpaid 
interest  ....  should  be  made  a  capital  obligation,"  ^^  said 
the  Commission.  "The  unpaid  interest  is  properly  chargeable 
to  income,  and  the  present  condition  of  the  finances  of  the 
company  ....  justifies  such  payment"  (i.e.,  out  of  in- 
come)." The  headnote  of  the  opinion  reads:  "Accrued  and 
unpaid  interest  should  be  paid  from  income,  and  an  authoriza- 
tion of  bond  issue  with  which  to  pay  such  interest  denied." 

§211.     (2)  Refunding  Operations 

Funded  debt  is  refunded  when  its  claims  upon  the  debtor 
are  satisfied  by  exchange  for,  or  out  of  the  proceeds  of,  a  new 
issue  of  funded  debt,  the  identity  of  the  debtor  remaining  the 
same. 

Exchange  for,  or  out  of  the  proceeds  of,  a  stock  issue  would 
not  constitute  refunding;  the  debt  would  be  completely  dis- 
charged. To  exchange  stock,  or  redeem  it  out  of  the  proceeds 
of  a  bond  issue,  would  be  an  extremely  rare  situation,  and  it 


•Matter  of  Erie  R.  R.  Co.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  4711   (4^7-4/^). 
"  Matter  of  Central  New  England  Ry.  Co.,  2  P.  S.  C.  (2nd  D.,  N.  Y.)  205^ 
"/d,,  pages  591,  596. 


450 


CAPITALIZATION 


could  not  be  described  as  a  refunding  operation.  The  Maine 
Central  Railroad  Company  some  time  ago  proposed  to  retire 
$10,000,000  of  its  common  stock  by  issuing  (i)  preferred 
stock  of  $3,000,000,  having  no  voting  power,  cumulative  at  5 
per  cent,  preferred  as  to  assets  and  callable  at  105;  and  (2) 
first  and  refunding  mortgage  twenty-year,  4^^  per  cent  bonds 
to  the  amount  of  $7,000,000  par  value,  dated  December  i, 
191 5.  There  was  no  attempt  to  secure  the  authorization  of 
the  Maine  Public  Utilities  Commission  on  the  merits  of  the 
proposed  issue  as  warranted  by  the  Public  Utilities  Act,  for 
authority  to  issue  these  particular  securities  was  expressly 
conferred  upon  the  company  by  special  legislation  of  191 5/' 

The  necessity  for  refunding  operations  is  taken  as  a  matter 
of  course.  The  larger  utilities  and  practically  all  the  railroads 
could  not  by  any  possible  means  make  adequate  provision  foi 
the  retirement  of  their  funded  debt  issues  upon  maturity,  so 
that  refunding  is  continually  resorted  to.  In  fact,  these  cor- 
porations would  not  be  permitted  by  the  commissions  regulat- 
ing rates  to  include  in  their  charges  any  provision  specifically 
for  discharging  their  funded  debts.  The  inconsistency  of  the 
public  lies  in  this,  however:  that  although  they  will  take  it  for 
granted  that  the  funded  debt  will  be  continued  indefinitely  in 
one  form  or  another,  they  will  not  give  as  good  support  to  an 
issue  of  extra-long-term  bonds  which  would  obviate  the  ex- 
pense and  inconvenience  of  refunding  as  they  will  do  to  an 
issue  which  in  forty  or  fifty  years  must  be  refunded. 

Refunding  operations  may  indicate  two  situations:  First, 
the  existence  of  an  immediate  claim  for  payment  of  a  debt 
through  maturity  of  a  bond  according  to  its  terms  through  (a) 
the  expiration  of  its  life,  (b)  the  exercise  of  some  option  by 
the  bondholder,  or  (c)  the  default  in  payment  of  interest,  or 
the  omission  or  commission  of  some  act  on  the  part  of  the 
corporation  such  as  will  make  the  entire  amount  of  debt  imme- 
diately payable;  the  last  condition  usually  merges  refunding 

^^See  1915  P.  U.  R.-F  1033;  in  re  Maine  Cent.  R.  R.  Co. 


CAPITALIZATION    FOR    SUNDRY    PURPOSES 


451 


operations  into  reorganization  proceedings.  Second,  refund- 
ing operations  may  indicate  that  the  debtor  corporation  has 
entered  upon  a  project  of  refinancing,  presumably  for  its  own 
and  direct  benefit,  e.g.,  by  exercising  an  option  to  redeem  or 
retire  a  certain  issue  prior  to  maturity,  usually  because  it  can 
place  a  refunding  issue  to  better  advantage  than  it  can  con- 
tinue the  outstanding  issue.  It  may  also  be,  and  often  is,  that 
such  refinancing  is  undertaken  by  mutual  consent  of  bond- 
holders and  the  corporation,  usually  to  avoid  disastrous 
receiverships  or  reorganization. 

The  cost  of  discharging  or  refunding  is  the  most  impor- 
tant consideration  in  the  analysis  of  a  refunding  plan.  The 
period  elapsed  since  the  debt  to  be  refunded  was  first  issued 
is  usually  so  great  that  the  consideration  of  the  purposes  to 
which  the  proceeds  were  originally  applied  is  no  longer  ma- 
terial, except,  of  course,  where  there  is  a  very  strong  proba- 
bility that  the  issue  had  been  made  the  means  of  gross  over- 
capitalization. A  presumption  of  proper  original  issue  will 
usually  prevail  unless  specifically  attacked. 

The  cost  of  discharging  or  refunding  would  include  two 
factors:  first,  the  excess,  if  any,  of  the  par  value  of  the  re- 
funding over  the  refunded  issue;  second,  the  net  interest  bur- 
den of  the  new  issue  as  compared  with  the  old.  In  this 
calculation  the  discount  to  be  suffered  on  the  new  issue  of 
bonds  must  be  considered;  if  the  debt  to  be  refunded  has  not 
matured. by  the  expiration  of  its  term  so  as  to  be  payable  at 
par,  the  premium  to  be  paid  or  the  market  price  at  which  to 
be  repurchased  will,  of  course,  also  enter  into  the  computation. 

It  is  elementary  that  the  refunding  issue  shall  bear  a  proper 
relationship  to  the  debt  to  be  refunded — so  elementary  that 
the  statutory  provision  would  seem  superfluous,  yet  the  pro- 
vision was  inserted  in  a  proposed  statute  ^^  that  "in  no  case 
shall  the  amount  of  securities  outstanding  be  increased  by  the 


'^  Proposed  federal  bill  of   1913   giving  Interstate  Commerce  Commission  authority 
over  issue  of  securities. 


452 


CAPITALIZATION 


refunding."  The  enactment  of  any  such  rigid  rule  would  be 
extremely  unwise.  In  long-term  obligations,  the  par  value 
might  not  be  of  as  great  importance  as  the  amount  of  annual 
interest  charge. 

The  New  York  Public  Service  Commission  for  the  Second 
District  in  1908  refused  to  authorize  the  issue  by  a  railroad 
corporation  of  $900,000  par  value  of  5  per  cent  bonds  "ma- 
turing not  later  than  100  years,"  of  which  $500,000  were  to 
be  applied  to  the  immediate  retirement  of  an  equal  amount  of 
unmatured  4  per  cent  bonds  (to  mature  in  1924),  "If  the 
new  bonds  could  also  bear  4  per  cent  interest  and  be  sold  to 
advantage  at  this  time,  the  immediate  retirement  therewith 
of  the  present  outstanding  4  per  cent  bonds  would  probably 
not  be  open  to  objection ;  but  the  proposal  to  retire  a  4  per  cent 
bond  having  about  sixteen  years  still  to  run  with  a  new  5  per 
cent  bond  maturing  in,  say  forty  years,  does  not  commend 
itself  to  this  Commission,  in  the  absence  of  definite  and  ap- 
proved arrangements  to  effect  an  exchange  which  would  save 
the  company's  treasury  from  any  actual  loss  in  the  transaction 
and  which  would  cover  the  exchange  of  the  whole  series  of 
old  bonds  for  the  new.  In  other  words,  our  order  should  not 
operate  to  increase  the  interest  charge  upon  this  property  by  i 
per  cent  or  any  per  cent  for  the  next  sixteen  years  without 
some  corresponding  increase  in  the  company's  assets  in  prop- 
erty or  in  cash  to  be  devoted  to  the  construction  and  improve- 
ments covered  by  the  case  under  consideration.  Indeed,  it  may 
be  questioned  whether  a  present  low-interest-bearing  bond 
should  be  permitted  to  be  retired  by  a  bond  bearing  higher 
interest  in  any  event  when  the  present  bond  would  run  a  rea- 
sonable period  before  maturity.  The  better  course  would  be, 
in  case  4^  or  5  per  cent  interest  is  found  necessary  for  the 
new  bonds,  to  require  that  500  of  the  new  bonds  be  held  in  the 
treasury  of  the  company  with  which  to  take  up  the  present 
bonds  at  maturity  in  1924."  ^* 


**  Matter  of  Greenwich  &  Johnsonville  R.  R.  Co.,  i  P.  S.  C.  Rep.  (2nd  D.,  N.  Y.)  36. 


CAPITALIZATION    FOR    SUNDRY    PURPOSES 


453 


In  connection  with  another  application  (decided  July, 
1908)  involving  authorization  of  4  per  cent  first  and  refund- 
ing mortgage  bonds  to  retire  from  time  to  time  outstanding 
$5,000,000  7  per  cent  bonds  maturing  in  19 17,  $500,000  6  per 
cent  bonds  maturing  in  1924,  and  $1,000,000  of  4^^  per  cent 
bonds  maturing  in  1942,  the  Commission  said:  "The  pro- 
visions in  the  proposed  mortgage  as  to  the  manner  of  retiring 
and  finally  cancelling  these  present  bonds  through  exchange 
therefor  of  bonds  under  such  proposed  mortgage  or  of  pur- 
chase thereof  from  funds  in  the  applicant's  treasury,  or  of 
sale  of  the  new  bonds  are  approved,  but  it  is  evident  that 
during  periods  of  from  nine  to  thirty-four  years  the  terms 
of  possible  exchange  or  of  sale  of  the  new  bonds  must  be 
variable.  It  is  also  apparent  that  the  applicant  will  endeavor 
to  secure  the  present  outstanding  bonds  from  time  to  time  as 
opportunity  may  offer.  We  think  that  when  it  has  been  ar- 
ranged that  any  of  these  new  bonds  shall  be  exchanged  for 
any  of  the  underlying  bonds,  or  whenever  it  is  desired  to  sell 
any  of  these  new  bonds  in  order  to  purchase  any  of  the  under- 
lying bonds,  the  terms  of  exchange  or  sale  should  first  be 
submitted  to  the  Commission  for  approval,  provided,  however, 
that  such  exchange  may  be  made  par  for  par,  without  payment 
of  any  premium  on  the  old  bonds  by  the  applicant  from  its 
treasury,  at  any  time  without  such  approval."  ^^ 

§  212.    The  Need  for  Constructive  Regulation  of  Finance 

There  is  no  greater  responsibility  than  that  of  using  other 
people's  money,  excepting,  of  course,  that  of  using  their  lives. 
The  commercial  and  financial  development  which  is  now 
valued  so  highly  is  based  upon  faith  in  the  discharge  of  that 
responsibility.     When  that  faith  fails,  crises  follow. 

The  responsible  task  of  corporation  finance  is  that  of  accu- 
mulating other  people's  moneys  for  use  in  corporate  under- 
takings.    True,  the  use  is  entrusted  to  directors  and  officers 


"  Matter  of  Delaware  and  Hudson  Co.,  1  P.  S.  C.  Rep.  (^nd  D.,  N.  Y.)  242  (271). 


454 


CAPITALIZATION 


representing  those  who  contribute  to  the  capital,  at  least  those 
who  do  so  through  the  purchase  of  capital  stock.  The  sole 
reason  for  public  regulation  of  capitalization,  however,  (the 
wisdom  of  which  is  so  amply  demonstrated  as  to  require  no 
argument  of  justification)  is  that  the  relationship  between 
those  who  use  the  funds  and  those  who  advance  or  loan  them 
cannot  and  must  not  be  considered  as  a  purely  private  trans- 
action of  no  public  interest.  This  is  true  because  in  many  of 
its  incidents  that  relationship  is  charged  with  or  affects  the 
welfare  of  the  public,  not  only  of  that  small  part  which  may 
be  brought  into  direct  contact  with  the  individual  corporate 
undertaking,  but  also  of  the  larger  part  whose  vital  interests 
are  bound  up  with  the  necessity  of  maintaining  financial 
integrity  and  supporting  credit. 

The  development  of  corporations  has  made  possible  a 
great  expansion  of  industry.  The  building  of  vast  transpor- 
tation systems,  the  harnessing  of  great  waterfalls,  the  girdling 
of  the  world  with  telephone  and  telegraph  lines — all  these 
have  been  made  possible  by  corporate  enterprise  supporting 
personal  genius.  These  have  been  agencies  counting  heavily 
for  social  progress;  those  who  made  the  corporate  support 
possible  as  well  as  those  who  supplied  the  creative  genius  have 
been  public  benefactors,  and  if  the  former  played  such  a  part 
when  the  responsibility  of  corporation  financing  rested  upon 
them,  it  must  be  that  those  who  are  now  charged  with  super- 
vision over  similar  projects  are  also  charged  with  part  of  a 
like  responsibility,  to  be  administered  not  merely  to  help  some 
few  men  to  make  money,  or  another  group  of  men  to  make 
wise  and  profitable  investments,  but  rather  that  social  and 
economic  progress  may  be  assured. 

Those  who  plan  corporate  projects  today  are  achieving 
just  as  big  things  as  many  of  those  upon  whose  past  accom- 
plishments we  now  look  back  with  satisfaction.  These  men 
must  not  be  fettered  nor  handicapped;  there  must  not  be  in 
supervision  over  them  men  of  small  caliber  who  lack  vision 


CAPITALIZATION   FOR   SUNDRY   PURPOSES  455 

and  seriousness  of  purpose,  or  who  are  indifferent  to  their 
opportunities  for  pubHc  service ;  above  all,  there  must  not  be 
in  this  responsible  position  men  who  cater  to  prejudice  and 
prostitute  the  truth  to  personal  expediency  and  the  garnering 
of  notoriety. 

It  will  be  said  that  men  of  this  caliber  cannot  be  attracted 
to  public  positions  at  the  salaries  which  the  public  can  afford 
to  pay;  that  in  private  occupations  such  men  make  more 
money.  If  this  were  wholly  true,  then  it  would  be  the  most 
potent  reason  for  abandoning  attempts  at  regulation  by  com- 
mission and  reverting  to  the  policy  of  centralizing  individual 
responsibility  on  those  who  put  themselves  in  the  position  of 
inviting  the  use  of  other  people's  money.  It  would  be  better 
to  have  no  regulation  than  to  have  improper  regulation.  The 
statement  is  not  true,  however,  and  it  has  not  been  true  wher- 
ever the  call  has  been  truly  that  of  a  public  service;  the  diffi- 
culty has  been,  and  it  unfortunately  continues  to  be,  that  the 
so-called  public  service  is  a  branch  of  politics:  party  regularity, 
party  support,  a  willing  ear  turned  to  the  makers  of  political 
destinies,  are  necessary  incidents  of  sharing  therein,  and  these 
incidents  are  obnoxious  to  the  men  who  want  to  do  big  things 
in  a  big  way. 

The  public  has  taken  a  wise  step  in  initiating  regulation 
over  capitalization  of  public  service  corporations,  but  it  de- 
mands constructive  regulation;  it  does  not  desire  that  in 
checking  the  abuse  of  corporate  privileges  it  shall  have  also 
dammed  and  held  back  the  onward  course  of  corporate  devel- 
opment; it  desires  that  its  commissions  shall  be  governed  by 
laws  framed  without  prejudice  and  administered  without  par- 
tiality ;  it  expects  policies  to  be  chosen  with  care,  and  adhered 
to  with  justice.  Its  demands  are  addressed  to  those  who 
frame  the  laws,  to  those  who  choose  and  appoint  commission- 
ers, and  to  those  appointed  as  commissioners  to  administer 
the  laws. 

What  is  the  function  of  a  commission  charged  with  the 


456 


CAPITALIZATION 


responsibility  of  regulation?  Shall  it  be  that  of  always  exer- 
cising a  negative  influence — that  of  being  a  cancellation  mark? 
It  is  well  enough  to  say  that  it  is  not  a  guarantor,  but  respon- 
sibilities cannot  be  brushed  aside  by  phrases.  Why  do  these 
commissions  exist?  A  great  deal  of  corporation  finance  was 
being  administered  before  their  advent  with  perfect  success 
and  absolute  integrity.  Of  course,  even  with  the  best  of  mo- 
tives and  the  most  conscientious  exercises  of  responsibility 
there  were  bound  to  be  differences  in  opinion  as  to  methods 
and  practices,  and  the  different  results  achieved  sometimes 
caused  misunderstandings  and  questioning  of  motives.  But 
taken  all  in  all,  so  far  as  the  acts  of  those  engaged  in  this 
financing  were  concerned,  there  was  no  failure  of  stewardship 
and  the  necessity  for  regulation  was  not  imperative.  There 
were  others,  however,  who  abused  opportunities  and  neglected 
responsibilities ;  upon  the  failure  of  their  stewardship  serious 
public  harm  ensued,  and  for  the  prevention  of  recurring  fail- 
ures regulation  was  instituted  by  the  decree  that  in  all  finan- 
cing decisions  a  vote  disinterested  and  therefore  impartial 
should  enter,  to  the  end  that  stewardship  might  be  more 
faithfully  carried  out. 

Regulation  of  capitalization  is  no  more  than  supervision 
over  the  task  of  corporation  finance  as  above  defined ;  it  there- 
fore consists  in  the  exercise  of  care  to  see  that  other  people's 
moneys  are  invited  for  proper  purposes,  under  a  reasonable 
and  fair  arrangement,  not  in  contravention  of  any  public  inter- 
est, and  that  they  will  be  properly  used  for  the  purposes 
intended.  The  commission  does  not  share  in  the  direct  re- 
sponsibility of  stewardship,  since  that  rests  solely  upon  the 
promoters  and  directors  in  their  relationship  to  the  stock- 
holders and  creditors,  but  it  does  share  in  the  responsibility 
for  the  policy  which  controls  the  plan  of  financing.  In  what 
spirit  shall  it  approach  that  responsibility?  On  the  answer 
to  this  question  rests  the  future  usefulness  of  the  public  service 
commissions  of  our  country. 


INDEX 

(References  are  to  pages.) 

A 

Abandonment, 

Restrictions  on  public  service  corporations,  20,  157,  170,  183  (See  also  "Public  ser- 
vice corporations") 

Accounting, 

Accuracy  in,  important  to  show  surplus  applicable  to  dividends,  116 
Defects  of,  hiding  financial  status,  116 
Discount  on — 

Bonds  issued,  223-4,  363-4  (See  also  "Discount:  bonds,  suffered  on  sale  of") 

Bonds  purchased,  222-3 

Stock  issued,  75,  76  (See  also  "Discount:  stock,  suffered  on  sale  of") 
Method  of  constructing  balance  sheet,  115 
Premium  on — 

Bonds  issued,  225-6  (See  also  "Premium:  bonds,  realized  on  sale  of") 

Bonds  purchased,  225 

Stock  issued,  75,  76  (See  also  "Premium:  stock,  realized  on  sale  of") 
Regulation   of — 

Indirect  regulation  of  capitalization  through,  269,  270 

Interstate  Commerce  Commission,  269,  299-301 

Public  service  commissions,  27,  122 
Terms,  indefiniteness  of,  77 

Accounts, 

Capital  in  and  costs  of  different  kinds  of  service  and  territories,  detail,  421 

Examination  of  books  of,  power  of  commissions,  27,  300 

Fixed  capital,  necessary  detail  for,  343 

Misstatement  of,  in  relation  to  overcapitalization,  298,  301 

Receivable  from  system  corporations,  separately  shown,  121 

Regulation  of,  as  aid  to  correcting  overcapitalization,  299 

Restatement  of,  may  be  required,  300-1,  343-5 

Valuations  or  appraisals  of  property  as  basis  of,  339-40,  435 
Uniform  systems  of,  established  by  commissions.  27 

Accrued  interest  on  bonds,  220-1 
Acquisition  of — 

Bonds,  subsidiary  companies. 

Economy  in  financing,  189-90  (See  also  "Collateral  bonds") 
Purposes  of  reinforcing  control,  189,  396,  398 
Property,  plant,  etc.. 

Authority  of  state  to  regulate,  in  general,  280,  385 
Public  service  corporations  to  obtain  authorization,  26-27 
Stock  and  bonds  of  other  corporations. 

Fair  value,  to  be  acquired  at,  and  capitalization  limited  to,  399-401,  40?,  404, 
406-9,  412 
Construction  value,  when  justifiable,  68 
What  constitutes,  68,  407-9 

457 


458 


INDEX 


Acquisition  of — Continued 

Stock  and  bonds  of  other  corporations — Continued 

Financing  of  subsidiary  corporations,  usual  method,  189-90,  396,  399-400 

Use  of  short-term  notes  in,  444-5 
From  proceeds  of  capitalization  when  obtainable  by  commission  authorization, 

286,  404 
Intercorporate  relationships  created  to  accord  with  public  policy,  404 
Operation  of  investing  corporation  not  to  be  unduly  burdened,  404-5,  410 

Capitalization  issued  for  this  purpose  to  be  identifiable,  405-406 

Case  of  holding  companies,  411 
Public  interest,  consideration  of,  402-3 

Purposes  of  investment  from  surplus  funds  (See  "Investments:  of  public  ser- 
vice corporations") 
Stock   of   other   corporations. 
Authority,  general,  94,  396 

Requiring   consent   of  commission,  27 

Restricted   in   respect  of  public   service  corporations,   27,   94-5,   396 
Purposes   of   control,   399-400 
Stock    of   own    issue, 

Authority,  general,  95-6 

Right  restricted  to  purchase  from  surplus,  or  acceptance  by  gift  or  in  settle- 
ment of  debt,   95 

Purpose    of    restriction,    95 
Status   of  reacquired   shares,   95 

Actions, 

Bondholders',  for  exercise  of  remedies,   if  trustee  refuses  to  act,  174 
Stockholders',   for  declaration  of  dividends,   130-1 

Acts, 

Of  corporation;  proportion  of  votes  required  to  authorize  at  stockholders'  meet- 
ings, 90 
Of  trustee,  binding  on  bondholders,  174 

Actual  issue, 

Terms  defined,  relating  to  stocks  and  bonds,  39 

Additions  to  fixed  capital, 

Accounting,  345 

Definition,  345 

Difificulty  of  distinguishing  from  replacements,  431 

Affiliated  corporations, 

Definition  of  relationship,   395   (See  also  "Intercorporate  relationships") 

After-acquired  property, 

Lien   of   existing   mortgage   to   attach,   167 

Distinction  between  rights  of  individual  and  corporation,  167 
Methods  of  deferring  lien  in  special  cases,  167 

Agency, 

Assumed  relationship  of,  between  public  and  public  service  corporations,  21-2 

Of  trustee  to  bondholders,   173-4 

Of  trustee  to  mortgagor  corporation,    174 

Agreement, 

Bondholders',   for  reorganization,   183 

Stockholders',   apportioning  incidents   of  proprietorship,   84,    104 

Voting  trust,   88   (See  also   "Voting  trust") 


INDEX 


459 


Amortization, 

Bond  discount  and  expense,  text  of  act,  224 

Bond  discount  and  premium,  224-5  (See  also  "Accounting") 

Funded  debt. 

Advantage  to  stockholders,  238-9 

Application  of  earnings  to,   238 

Burden  of,   equalizing,   245-6 

Through  serial   maturities,   245 
Through  sinking  funds,   246 

Call,   bonds  subject  to,   utility  in  program  of,  2i7,  238 

Extent  to  which  possible  in  public  service  undertakings,  237 

Methods  of,  237-8 

Necessity  for,   consideration  governing,  238 

Reacquisition  of  company's  securities,  233  (See  also  "Redemption  of  bonds" 
and  "Callable  bonds") 

Refunding  does  not  constitute,  239 

Required  by  bondholders,  when,  238 

Security,   increased   by,   238 

Serial  maturity  as  method  of,  237   (See  "Serial  maturity") 

Sinking    fund    as    method    of,    237    (See    "Sinking    funds") 

What  constitutes,  237 

Annual  report, 

Commission  may  require,  27  (See  also  "Reports") 

Anti-trust  acts, 

(See  "Clayton  Act") 

Apportionment  of, 

Control  over  corporation,  between  stockholders,  84,  104  (See  also  "Control") 
Earnings,  between  stockholder  and  bondholder,  13,  210 
Ownership  rights,  a  factor  in  task  of  corporation  finance,  12 
Risk  of  enterprise,  between  investors  in  loan  or  share  capital 

Interest  rate  on  bonds  affected  by,  210,  211,  214,  216 

Proportion  of  stock  to  bonds  controlled  by,  256,  258 

Appraisals, 

(See  "Valuations") 

Appreciation, 

Bond  values,  217,  222,  225 

Fixed  capital,  may  not  be  capitalized,  436-7 

"Writing-up"  of  accounts,  improper  use  in,  338 

Appropriations, 

To  fixed  capital,  out  of  income  or  surplus,  129-130 
Accounting,  129 
Capitalization   for    (See  "Reimbursement") 

Assets, 

And  liabilities,  constituting  balance  sheet,  115,  342  (See  also  "Balance  sheet") 

Depreciation  of  (See  "Depreciation") 

Intangible   (See  "Intangible   capital") 

Nature  of,  affecting  characteristics  of  bonds  issued,  193,  231,  245,  250 

Stock  preferred  as  to,  96,  98-9 

Value  of,  earnings  basis  of,  74 

Accounts   do   not   record,   77,    119,   339-40,   342   (See   also   "Fixed   capital:    Ac- 
counting," and  "Investments") 

Appraisals  to  determine  (See  "Valuations") 

Capitalization  limited  to,  69,  151 


460 


INDEX 


Assignment, 

Of  bond  or  stock  interest  (See  "Transfer") 

Auction, 

Issue  of  stock  by  sale  at,  70 

Authorized  capital  stock,  32 

B 

Balance  sheet, 

Book  values  appearing  on,  118,  119,  120,  123 

Construction  of,  methods,  115 

Difficulties  of  obtaining  accuracy  in,   116 

Financial  status  of  corporation  reflected  by,  186-7,  342 

Inadequacy  of,  116,  118 

Solvency,  measure  of,  118,  342 

What  constitutes,  118 
Statement  of  assets  and  liabilities,  115,  342 

Bank  discount, 

Distinguished  from  true  discount,  215 

Bankers, 

Affiliations  with  railroad  corporations,  151 

Attitude  towards  work  of  public  service  commissions,  275 

Function  of,  in  corporation  financing,  148 

Part  in  developing  corporate  advantages,   148 

Relations  with  clients,  affecting  corporations,  148 

Bankruptcy  (See  "Default") 
Bearer, 

Payee  of  coupon  bonds,  161 

Bearer  bonds, 

Negotiability  of,  163-4 
Transfer  by  delivery,  163 

Bearer  shares, 

Not  used  in  United  States,  SO 

Betterments  of  fixed  capital, 

Accounting  for,   118,  345 

Definition,  345  (See  also  "Fixed  capital") 

Blanket  mortgage. 

Definition,  200   (See   also    "General   mortgage") 

Board  of  Railroad  Commissioners  (See  also  "Public  service  commis- 
sions") 

Creation  of,  25,  309 
Powers  of,  25,  311 

Bond  dividends, 

Definition,  135 

Statutory  restrictions  on,  135-8 

Stockholders'  interest  in  proprietorship  converted  into  claim  against  corporation, 
138 


INDEX  461 


Bondholders, 

Actions  by,  if  trustee  does  not  act,  174,  181 

Beneficiaries   of   corporate   deeds   of   trust,   158 

Bound  by  acts  of  trustee,  174 

Control  over  acts  of  corporation,  to  reinforce  security,  170 

Conditions  of  mortgage  placing  specific  duties  upon  corporation,   171-2 
Appropriating  earnings  to  maintenai.ee  and  depreciation,  172 
Limitations  en  capitalization,  172 

Contingency  of  exercising  lien,   171,  396 

Contingent,    what    constitutes,    396 

Limited  nature  of,   170-1 
Equal  rights  and  benefits   of,  158-9 
May   not  proceed  as   individual   creditors,   158 
Option  to  exercise  remedies,  181 
Purchase  of  mortgaged  property  by,  183 
Remedies  of,  on  default  of  corporation  (See  "Remedies  of  bondholders") 

Exercise  of,  subject  to  public  policy,  168,  170,  183 

Exercise  of,  through  trustee,  159,  181 

Bondholders  may  direct  action  of  trustee,  181 

On  default  of  trustee,  bondholders  may  act,  174,  181 

Resort  to,  constitutes  distributing  element  in  corporation  finance,  255 
Stockholders  distinguished  from,  210-11 

Bonds, 

Agreement  of,  incorporated  in  trust  deed,  159,   162 

Parties  to,   160-161 

Promise  to  pay  principal  and   interest,  159-60 

What  constitutes,  158 
Amount  of  issue  of,  in  relation  to  capitalization   (See  "Proportion  between  stock* 
and  bonds") 

Limitations  of  mortgage  on,  172-3 

Restricted,   per  mile  of  road,   177 
Apportionment  of  incidents  of  ownership  represented  by,  12-13,  147,  210 
As  collateral   (See  "Collateral  bonds") 
As  personal  property,  206 

Authority   for  issue   (See   "Borrowing  money") 

Certification  of  trustee  required,   161   (See  also  "Certification  of  bonds") 
Characteristics    of,    controlled    by    nature    of    property    mortgaged    or    purpose    of 

issue,  193,  231,  245,  250  (See  also  "Equipment  obligations") 
Classification  of,  according  to — 

Form,  161  (See  also  "Coupon  bonds"  and  "Registered  bonds") 

Method  of  redemption,  186 

Property  mortgaged,  185 

Purpose   of  issue,    186 

Ranking  order  of  liens,  186 

Security,  185,  187 

Terms  in  years,  186 
Convertible,  186,  235 

Coupon,  161  (See  also  "Coupon  bonds") 
Debenture  (See  "Debenture") 
Definition  of,  152 
Definitive,  160 
Denomination  of,  amount,  153  (See  also  "Denomination  of  bonds") 

Currency  in  which  stated,  159-160 
Dividends   (See   "Bond   dividends,"  above) 
Domicile  of,  212 

Equipment,  192  (See  also  "Equipment  bonds"  and  "Equipment  obligations") 
Execution  of  certificate  for,  161 


462 


INDEX 


Bonds — Continued 

Financing  by  issue  of,  place  in  corporation  finance,  12,  147  (See  also  "Trading  on 

the  equity") 
Guaranty  of,  by  another  corporation,  206 
Interest  on  (See  "Interest") 
Interchangeable,  162 
Interminable,  229 
Issue   of,    to   be   authorized   by   commission,   27    (See   also   "Regulation   of   stock 

and  bond  issues") 
Legal   investments,   200,   266 
Market  for,  compared  with  stock,  2S4 

Effect  on  determining  proportion  to  stock,  265 
Maturity,  no  date  of  (See  "Irredeemable  bonds") 

Mortgage  to  secure  (See  "Mortgage"  and  "Security  for  funded  debt") 
Negotiability  of,  152,  163-4 
Non-negotiable,  when,  152 
Notes  and,  compared,  152 
Par  value  of  (See  "Denomination") 
Payee,  bearer  of  coupon  bonds,  161 
Payee,  named  on  registered  bond,  162 

Payment,  terms  of,  indicated  by  bond  titles  and  classified  according  to,  186 
Proportion  to  stock,  251   (See  also  "Proportion  between  stocks  and  bonds") 
Purpose  of,  indicated  by  bond  titles  and  classified  according  to,  186 
Reacquired,  status  of,  247,  249 
Redeemable,  186  (See  also  "Redeemable  bonds") 
Kefunding,  201 

Registered,  161-62  (See  also  "Registered  bonds") 
Serial,  186,  239   (See  also  "Serial  maturity") 
Stock  distinguished  from,   152-3 
Straight,  186,  239 

Taxation  of,  2C6-207  (See  also  "Taxation") 
Taxes  on,  income  from,  assumed  by  corporation,  160,  208-9 
Temporary,  160 
Terminal,  186,  188 

Term  of,  186,  229  (See  also  "Term  of  bonds") 
Unauthorized,  void  by  statute,  275 

Penalties  for  issue,  275 
Validity  of,  laws  of  state  governing,  149,  S80 

Bond  titles. 

Ambiguity  of,  185,  198 

Property  mortgaged,  indication  of,  185-6 

Purpose  of  issue,  indication  of,   186 

Ranking  order  of  liens,  indication  of,  186 

Reinforced  security,  indication  of,  187 

Significance  of,  185 

Terms  or  method  of  payment,  indication  of,  186-7 

Bond  values. 

Appreciation  or  depreciation  in,  if  purchased  on  basis  rate,  217,  222,  225 
Ignorance  of,  as  cause  of  undue  proportion  of  bonds  in  financing,  254 
Income  as  test  of,  219,  221 
Serial  maturities,  causing  variation  in,  239 

Bonus  stock, 

Issue  of,  SB 

Rights  and  liabilities  of  holder,  57 

Stock-watering,  58 


INDEX  463 

Books, 

Of  account,  jurisdiction  of  commission  over,  27 

Examination  of,  must  be  thorough  if  used  as  basis  of  restatement,  300 
Stock   (See   "Stock:    book") 

Book  surplus. 

Distinguished  from   "real,"   118-20 
Relation  to   determination  of  profit,   123 

Book  value. 

Of  fixed  capital,  118-120 

Borrowing  money, 

Authority  for  (See  subhead  below,  "Power  of  contracting  debt") 
Exercise  of  right,  laws  of  state  governing,  149 

Regulation  of,  by  charter,  280,  284-5 

Regulation  of,  by  statute,  151,  273 
Function  of,  in  corporation  finance,  147,  255  (See  also  "Trading  on  the  equity") 
Limitations  on  amount,  151 

"Loan  capital,"  for  accumulation  of,  148  (See  also  "Loan  capital") 
On  bond  issue,   151 
On  credit  of  corporation,   154 
Payment  of  dividends,  132-3 

Power  of  contracting  debts  and,  12,  148,  280,  284-5 
Security  given  by  corporation,  154  (See  also  "Mortgage"  and  "Security  for  funded 

debt") 
Sources  available  for,  151,  154 

Bribe, 

Exercise  of  voting  rights  under,  86-7 

Bridge  bonds,  186,  188 
Bridge  companies. 

As  public  service  corporations,   17 

Bubble  Act, 

Enactment  of,  4 

Burden  of  Amortization, 

Equalization  of,  necessary,  245 

Serial  maturities  effecting,  245  (See  also  "Serial  maturity") 

Sinking  fund  effecting,  246  (See  also  "Sinking  fund") 

Business, 

Expansion  of,  affecting  development  of  corporations,  12 

By-laws, 

Classification  of  capital  stock  in,  97 
Corporation,  management  of,  regulated  by,  85 
Stockholders'  rights,  limitations,  84 

c 

Call, 

Bonds  subject  to,  186,  233   (See  also  "Callable  bonds") 
Stock  subject  to,   108  (See  also  "Callable  preferred   stock") 
Subscription  agreements,   payments  on,  43 

Callable  bonds, 

Advantages  of  to  corporation,  233 
Definition,  186,  233 


464 


INDEX 


Callable  bonds — Continued 

Disadvantages  to  bondholders,  234 

Compensation  for,  by  payment  of  premium,  234 

Effect  or  possible  appreciation  of  bond  value,  234-5 
Drawing  by   lot,  234 
Utility  in  program  of  amortizing  debt,  238 

Callable  preferred  stock. 

Computation  of  yield,  221 
Definition,   100,   108 
Premium  paid  on,  108 

Capital, 

Accumulation  at  organization,  31 

Building  up   out   of  earnings,   129-30,  336-7   (See  also   "Income:   appropriations   for 

fixed  capital  investment") 
Capitalization  and,  compared,  267,  269 

Impossibility  of  maintaining  comparative  values,  296,  299 

Proper  relationship  required  by  statute,  260-1,  302 
Capital  stock  and,  compared  and  distinguished,  31,  32-3,  34,  54 

Attempt  to  maintain  comparability  of,  in  accounting,  64,  338 
Classification  of,  fixed  and  floating,   335-36 

Accounting,  necessity  of  maintaining  distinction  in,  267 

Rule  to  distinguish,  335-6 
Definition,  31,  32,  335 

Distribution  of,  among  stockholders,  95,  113-4,  124  (See  also  "Dividends") 
Facility   for  accumulating,   an  advantage  of  corporate  form,  31 
Invested,  integrity  of  to  be  maintained,  288,  307 
Loan  (See  "Loan  capital") 
Share  (See  "Share  capital") 

Capitalization, 

Abuses  of,  commission  regulation  to  remedy,  295 

Methods  of  correcting,  295-6 

Propriety  of  acts  at  time  committed  to  be  considered  before  condemning,  305 
Acquisition   of  stocks  and   bonds;   expenditures   subject  to,  286   (See  also  "A'cqui- 

sition") 
Appraisals  of  company's  property  in  reJation  to  (See  "Valuation") 

Care  to  be  used  in  making  comparison,  434-5 
Capital  and,  compared,  267,  269 

Impossible  to  maintain  comparative  values,  296,  299 

Proper  relationship  required  by   statute,  2601,  302 
Collateral  aspects  of  regulation  over,  308 
Construction  costs  (See  "Construction") 
Deficits,   improper,  440-2 
Definition  of,  286,  289 
Development  expenses,  440 
Direct  regulation,  what  constitutes,  268-9 

Exercise  of  by  state  commissions  (See  "Regulation  of  stock  and  bond  issues") 

Purpose  of  statutes  conferring,  288-9 
Existing,  correction  of  alleged  improprieties   (See  also  "Overcapitalization") 

Paring  down  of  securities,  impracticability   of,  295-6 

Power   of   Commissions   to   attempt   correction,   294-5 
Direct  powers  not  retroactive,   294-5 
Federal  regulation  of,  indirect,  269  (See  also  "Interstate  Commerce  Commission") 

Attempts  to  give  power  of  direct  regulation,  270-2 


INDEX  465 

Capitalization — Continued 

Fixed  capital,  financing  acquisition  of  (See  "Fixed  capital:  capitalization  for  pur- 
poses of") 
Funding  operations,  incident  to  (See  "Funding  operations") 
Increase  of,  considerations  controlling. 

Alleged  overcapitalization   (Sec   "Overcapitalization") 

Examination  of  accounts,  300 

Financial  condition  of  corporation,  303 

Limitations   upon  inquiry,  304 

Past  record  of  corporation,  303-4 

Arbitrary  use  of,  to  be  avoided,  305 
Indirect  regulation  of,  what  constitutes,  269,  274-5 

Exercise  of,  by  state  commissions,  274-5 

Interstate  Commerce  Commission,  269 
Intangible  capital,  acquisition   (See  "Intangible  capital") 
Investments   not    subject   to,   406,   413-4 
Issue  of,  authorization  of  commission  required,  27,  34,  279,  284 

Penalties  for  unauthorized,  275 

Right  declared  to  be  a  special  privilege,  283-4 
Limitation  upon  amount,  based  on  value  of  assets,  69,  151,  296,  302 
Operating   expenses,   capitalization   for  when  allowed    (See   "Maintenance  or   im- 
provement of  service") 
"Outside  properties,"  investments  in,  not  subject  to,  414 

"Overcapitalization,"  effect  of  on  proposed  additional  (See  "Overcapitrlization") 
Par  value  of,  distinguished  from  investment  in  capital,  268 
Probable  return  on,  proper  for  commission  to  consider,  292,  327-8 
Proceeds,  application  of  to  purposes  specified  by  commission,  27,  178,  286  (See  also 

"Proceeds    of    capitalization") 
Public  service  corporations,  public  interest  in,  267-8 
Purchase  of  plant,  for  purposes  of  financing  (See  "Purchase  of  plant") 
Purposes  for  which  intended. 

Aspect  of  capitalization  best  regulated,  274 

Control  issue,  289 

Enumeration  of,  general,  286,  296 
New  York  statute,  286-8,  296 

Examination  of,  by  commission,  286 

Importance  of  carefully  considering,  267 

Regulation  of,  274 
Rates  and,  relationship  between,  267-8,  320-323 
Reasonableness  of,  290 

Refunding  operations,  incident  to  (See  "Refunding  operations") 
Regulation  of,  demand  for,  267  (See  also  "Regulation  of  stock  and  bond  issues") 
Reimbursing  income  out  of,  for  moneys  expended  on  fixed  capital,  426  (See  also 

"Reimbursement")  , 

Reorganized  corporation,  422  (See  also  "Reorganization") 
State, 

Express  declaration,  California,  326 

Jurisdiction  of,  overcapitalization   (See   "Stock  and   bond  issues,  jurisdiction 

of  commissions") 
Not  a  guarantor  of  authorized,  322,  325 
Statute,  regulation  by,  69,  151,  273 
Tangible  capital,  acquisition  (See  "Tangible  capital") 

Capital  stock,    (See  also  "Stock") 

Authority  for  issue  of,  34,  279,  284 

Authorized,   definition,   32 

Balance  sheet,  entered  on  at  par,  55 


466 


INDEX 


Capital  stock — Continued 

Capital  and,  compared,  31,  32-3,  34,  54 
Certificate  of,  32   (See  also  "Certificate") 
Classification  of,  34,  96 

Authority  for,  generally,  96-7 

Consent  of  commission,  when  required,  97 

Divergent  interests  introduced  by,  105 

Effected  by  charter  or  by-laws,  91 

Effect  of,  96 
Common  (See  "Common  stock") 

Credit,  issue  of,  as  representing  extension  of  credit,  57,  297-8  (See  also  "Credit") 
Definition,  general,  32-3,  370 

For  purposes  of  taxation,  51 
Dividend  payments  out  of,  prohibited  (See  "Dividends") 
Founders'  shares,  110 
Increase  of,  35 
Interest-bearing,   109 

Issue  of,  to  be  authorized  by  commission,  27  (See  also  "Regulation  of  stock  and 
bond  issues") 

Consideration  to  be  realized  (See  "Consideration") 

Expenses  of,  proper  charge  to  capital,  362 
Implied  powers  of  corporation  to  make,  11-12 

Inherent  in  corporate  form,  12,  34,  47,  279 

Unauthorized,  void  by  statute,  275 
Penalty  for  issue  of,  275 

What  constitutes,  38,  39 
New,  offered  to  stockholders  of  record,  263 
Obligation  of  corporation  for,  32-3,  49,  54,  99-100,  152 
Par  value  of  (See  "Par  value") 

Proprietorship  indicated  by,  33-4,  36  (See  also  "Stockholders:  proprietorship") 
Redemption  of,  out  of  bond  issue,  449-50 
Reduction  of,  35 

Shares  of,  32  (See  also  "Shares") 

Special  classes  of,  resembling  creditors'  claims,  100,  109-10 
Subscriptions  for  (See  "Subscriptions") 
Taxation  of,  51  (See  also  "Taxation") 
Transferability,  essential  characteristic  of,  47  (See  also  "Transfer:  shares  of  capital 

stock") 
Validity  of,  laws  of  state  governing,  279 
Value  of,  33 

Corporate  surplus  or  deficit,  balance  of,  relation  to,  33-4  (See  "Corporate  sur- 
plus or  deficit  account") 

Par  value  compared  with  real,  55,  64-5,  72,  76-8,  298 

Taxation  purposes,  51-2 
Withdrawal  of  by  stockholders,  prohibited,  95 

Carrier  and  non-carrier, 

Properties  distinguished,  414 

Car-trust  bonds,  192 
Car-trust  certificates,  192 
Certificate  of  capital  stock. 

As  personal   property,  47,  51 

As  receipt,  32,  34 

Book  record  to  be  kept  of  issue,  Vl 


INDEX  467 


Certificate  of  capital  stock — Continued 

Definition,  32 

Delivery,  effect  of,  39 

Execution  of,  38 

Form  and  recital  of,  32,  37,  47 

Negotiability  of,  49,  50 

Shareholders'  contribution  and  interest,  evidenced  by,  34,  36 

Transfer  of  (See  "Transfer:  shares  of  capital  stock") 

Transferor  and  transferee,  rights  of,  in  respect  of  dividends,  47 

Transferor  of,  warranties  to  transferee,  SO 

Certificate  of  deposit. 

Issued  to  members  of  voting  trust,  88 

Certificate  of  incorporation,    (See  also  "Charter") 

Authority  for  execution  of  (See  "General  laws,  incorporation  under") 
Capital  stock,  provisions  contained  in,  34 

Classification,  34,  97 

Reasonable  restrictions  on  ownership  of  shares,  47 

Voting  rights  of  stockholders,   84 
Corporate  charter,  11 
Filing  of,  requirements  for,  11 
Incorporation  eflective  on  filing,  11 
Incorporators,  qualifications   of,   1,   2,   3,  94 

Certificate  of  indebtedness  (See  "Bonds,"  and  "Notes") 
Certificate  of  interest  (See  "Shares  without  par  value") 
Certificate  of  public  convenience  and  necessity. 

Commission  to  grant  before  railroad  may  be  constructed,  26 
Conditions  leading  up  to  regulation  of,  309-12 
Regulation  to  prevent  construction  of  bankrupt  roads,  321 

Certificate  of  voting  trust,  88 
Certification  of  bonds, 

Conditions  precedent,  176 

Limitations  upon  amount  per  mile  of  road,  177 

Purpose  of  requiring,  175-6 

Responsibility  of  trustee  in  making,  177 

Trustee  to  make,  161,  175 

Charter  of  corporation,    (See  also  "Certificate  of  incorporation") 

Definition,  367 
Early  history  of,   3-4,  9-10 
Grantees,  natural  persons,  1,  2,  3,  94 
Grantor,  generally,  1,  8 

Federal  government  as,  9 
State  as,  9-11 
Management  of  corporation  regulated  by,  85 
Power  of  amending,  reserved  by  state,  11,  278-9 
What  constitutes  under  general  laws,  11 

Chattel  mortgage, 

Definition,  155,  165 

Personal  property  lien,  155,  165 

Pledge,  distinguished  from,   155 

Circulating  capital  (See  "Floating  capital") 

Civil  corporations,  6,  7  (See  also  "Stock  corporations") 


468  INDEX 

Clayton  Act,  29,  30 
Closed  mortgage,  160 
Collateral  bonds. 

Convertible,    191 

Definition,  186-7,  189 

Financing  projects  of  subsidiary  corporations  by,  189-90,  396,  399 

Fixed  charges  substituted  for  dividends  on  stock  collateral,  401,  410 

Necessitated  by  restrictive  state  laws,  397-9 
Security  for,  classification  of  collateral,  189 

Bonds  of  subsidiary  corporations,  189-90,  396,  399 
Mortgage  incidence,  190 

Company's  own  bonds,   189,  191-2 

Custody  of  trustee,   178-9 

Foreclosing  lien  on,  180 

Income   fromm  disposition  of,  179-80 

Return  on,  relation  to  interest  rate  of  issue,  179,  401,  410 

Right  of  substitution,   191 

Securities  not  of  subsidiary  companies,   189,  190-1 
Effect   on  term   of  bonds,   191 

Stock  held  as  collateral,  189,  399-400,  401,  412 
Voting  rights  on,  by  whom  exercised,  179-80 

Trustee,  duty  of,  in  connection  with,  173-4,  179 

Value  of,  if  consisting  of  securities  of  subsidiaries,  190 

Collateral  mortgage  bonds,  190 

Collateral  trust  bonds  (See  "Collateral  bonds") 

Collateral  trust  notes,  191 

Combinations    (See  also  "Consolidations,"  and  "Intercorporate  rela- 
tionships") 

Public  policy,   404-5 

Restrictions  on,  396  (See  also  "Clayton  Act") 
Through  holding  company,  411 
Stock   ownership,  399-400 

Commissions, 

Gas  and  electricity.  New  York,  312 

Regulation  by   (See  "Public  service  commissions") 

Sale  of  stock,  payment,  71,  76 

Committee, 

Bondholders',  reorganization  proceedings,  183,  423 
Stockholders',  to  secure  concerted  action,  89 

Common  carriers, 

Classes  of,   17 

Definition,  15,  16 

Private  carriers  distinguished  from,  16 

Public  service  corporations,  17 

Special  duties  of,  15-6 

Common  stock, 

Classification,  instance  of,  98 

Conflict  of  interest  with   preferred,   105 

Control,   solely  vested     in,   106-7 

Limitations  upon,  in  favor  of  preferred  stockholders,  106 
Definition,  97 
Equal  rights  of  holders,   98 


*l: 


INDEX  469 

Competition, 

Elxisting  enterprises  to  be  protected  frotn    (See  "Existing  public   service   Enter- 
prises") 

Free,  in  public  service  field,  effects  of,  34,  309-12 

Consolidation  of  competing  companies  resulting  from,  308 

Regulation  of,  26,  309,  321 

Concerted  action  of  stockholders, 

Difficulty  of  obtaining,  89 

Minority  control  arising  from  absence  of,  89-90 

Pooling  arrangements  to  obtain,  88,  89 

Condemnation,  power  of. 

Definition,  310 

Grant  of,   unrestricted,   effects,   24,   310 
Improper    use    of    by   private    corporations,    24 
Regulation,   necesssity  for,  24-S,  310,  321 

Conditional  sales. 

Distinguished  from  chattel  mortgage,  194 
Equipment  trust  obligations,  use  in,  194 

Congress, 

Authority  to  create  private  corporations,  9 

General    laws   of   incorporation,    power    to   enact,   9 

Interstate  commerce  controlled  by,  9,  28 

State  jurisdiction,  compared,  28 
Post-roads  controlled  by,  9,  29 

Consideration  realized  on  issue  of  securities. 

Amount  of  (See  "Price  of  issue") 

Cash,   when  required,   for  payment  of  stock,  42 

Forms  other  than,   purpose   of  allowing   payment,  41-2 
Contribution  of  definite  form  of  capital  necessary  for  issue  of  stock,  40 
Nature  of,  generally,  41 

Promissory  note  not  good,  for  capital  stock,  42,  43-4 
Property,  labor,   or  services,  41-2 

Value  to  be  determined  by  directors,  41-2,  59-60,  301 
Constructive,   when  justified,  67-8 
Determination,  difficult  if  directors  are  parties  in  interest,  42,  60 

Fraud,  allegation  of,  necessary  to  impeach,  59-60 
Elements  of,  required  to  exist,  60-1 

Personal  interest,  attempt  to  eliminate,  61-3 
Review  of  independent  tribunal,  63 
Publicity  of  incidents  of  issue,  61-2,  63 
"Stock-watering,"  alleged,  58-9  (See  also  "Watered  stock") 

Consolidated  and  general  mortgage  bonds,  201 
Consolidated  first  mortgage  bonds,  201 
Consolidated  mortgage  bonds,  186,  200-1 
Consolidated  refunding  mortgage  bonds,  201 
Consolidations  (See  also  "Combinations") 

Accounting  of  new  company,  special  consideration  of,  421 
Anti-trust   laws,  application   of,  419 
Capitalization  not  to  be  increased  by,  417-8 

New  York  statute,  417 

Purpose  of  prohibition,  417-8 

Value  of  consolidating  properties  to  control,  420 


470 


INDEX 


Consolidations — Continued 

Contract  of,  not  subject  to  capitalization,  375 

Definition,   416 

Exchange  of  securities  in,  basis  of,  418 

Overcapitalization  of  consolidated  company  to  be  avoided,  419 

Condition  of  consolidating  companies  may  be  examined,  419-20 
Public  policy   to  be  considered,   332,  404,  420-1 
Regulation  of,   by   commission,   419 
Sale  of  properties  by  two  or  more  companies  to  common  purchaser  equal  to,  419 

Constitution, 

California,  definition  of  public  utility,  18 

Delaware,    consideration   for   issue   of  stock,  41 

New  York,  incorporation  under  general  or  special  laws,  10-11,  279 

United  States, 

Interstate  commerce  clause,  28-9 

Post-roads  clause,  29 

Construction, 

Capitalization  for  costs  of,  379 

Determination    of    amount,    estimates    used,    379    (See    also    subhead    below 
"Costs  of") 

Fluctuations  to  be  provided  for,  379-80 
Costs  of,  what  constitutes,  341,  381  (See  also  "Cost") 

Accounting  for  detail  of,  380   (See  also  "Fixed  capital:  accounting  for") 

Apportioned  between  operation  and  construction,  385 

Estimate  of,  for  capitalization,  379,   383-4 

General  and  overhead  expenditures  entering  in,  381 
Engineering  and  superintendence  during,  381 
Injuries    during,    382 
Interest  during,   383 

Amount  of,   385-6 

Payment  of,  out  of  stock,  386-7 
Law   expenditures   during,   382 
Miscellaneous   expenditures   during,   383 
Operations  during,   accounting  for,  384-5 

Apportionment  of  costs  to,  385 

Loss  from,  disposition,  of,  385  (See  also  "Development  expenses") 
Period  of,  what  constitutes,  384-5 
Taxes  during,  382 
Under  contract,  general  considerations,  387,  388 

Abuses  of  capitalization  introduced  into,  387-8 

Accounting  for,  389 

Profit   of  contractors,   legitimacy   of,  389 

Terms  of  agreement,  review  by  commission,  388-9 

Construction  companies. 

Definition,   387 
Financing  through,  387-8 

Abuses  checked  by  commission  regulation,  388 

Contractors'  profits, 

Legitimacy   of,    in    cost    of   construction,    389 

Contract  rights, 

Capitalization   of. 

Abuses  in,   374-5 
When    warranted,   375 
For  lease  or  consolidation,   may  not  be  capitalized,  375 


471 


INDEX 
Contract  rights — Continued 

For  purchase  of  electricity  at  advantageous  rate  disallowed,  375-8 
Intangible  capital,  358 

Control, 

Bondholders'   (See  "Bondholders") 

Contingent,  106 

Corporation,  exercising  over  another  corporation  (See  "Controlling  corporation") 

Definition,   in   intercorporate  relationships,   394-5 

General,  105-6,  396 

Joint,  what  constitutes,  395 

Majority  stockholders,  89  (See  also  "Majority  control") 

Minority  stockholders,  representation  in  (See  "Minority  representation") 

Over  corporation  vs.  over  property  of  corporation,  394 

Right  to  name  majority  of  board,  by  agreement,  395 

Sale,  what  constitutes,  395 

Specific,  106 

Stockholders'  (See  "Stockholders") 

Unified,   advantage   of  corporate   form,   31 

Controlling  corporation,     (See  also  "Holding  companies") 

Acquisition  of  stock  for  purposes  of  control,  399-400 

Affiliated  corporations,  definition,  395 

Capitalization    of,    for    financing    subsidiaries    (See    "Acquisition    of:    stock    and 

bonds") 
Relationship    to    subsidiary    companies    (See    "Intercorporate    relationships"    and 

"Control") 
Special  responsibilities  to  minority  stockholders,  92 
Value  to  be  placed  on  securities  held  as  means  of  control,  120 

Conversion,  right  of, 

Bonds,  186,  235 

Registered  and  coupon  bonds,  161-2 

Stock,   107-8 

Convertible  bonds,  186,  235 
Convertible  collateral  trust  bonds  or  notes,  191 
Convertible  preferred  stock,  107-8 
Corporate  enterprise. 

Personal  relationship  of  members  entering  into,  2,  31 

Corporate  existence, 

Change  in  membership  does  not  affect,  1,  3,  12 
Term  of,  1,  8 

Corporate  name. 

Implied  power  of  corporation  to  do  business  in,  sue  or  be  sued  in,  etc.,  12 

Corporate  surplus  or  deficit  account,    (See  also  "Deficit,"  and  "Sur- 
plus") 

Definition,  117 

Function  of  measuring  solvency,  116,  118,  342 

Matters  entering  into,  117 

Proprietorship,   index  of,  in  conjunction  with   capital   stock,   33-4,  55 

Profit  and  loss  account  of  industrial  corporations  compared,  117  (Note) 


472 


INDEX 


Corporation  commissions  (See  "Public  service  commissions") 
Corporation  finance, 

Elasticity   of,   288 

Influences  bearing  on  development  of,  12 

Instruments  of,  12-13 

Stock  corporation,  limited  to  affairs  of,  7 

Task  of,  13 

Corporations, 

Advantages  of  organizing  into  (See  "Stock  corporations") 

Charter  of  (See  "Charter,"  "Certificate  of  incorporation,"  and  "Incorporation") 

Classification  of,  into  public  and  private,  6 

Definition,  general,  1-3 

Legal  statement  of,  by  Supreme  Court,  1 
Development  of,   12-13  (See  also  "Joint-stock  associations") 
Government  of  officers,  agents,  and  business,  by  by-laws,  12 
Independent  entity,  1 
Private,  614,  267 
Public,  6 

Public  service,  14  (See  also  "Public  service  corporations") 
Stockholders  in  other  corporations,  27,  94-S,  396 

Cost, 

As  basis  of  accounting  for  fixed  capital,  77,  119,  337,  340-1 

Construction   (See  "Construction") 

Detail  to  be  recorded,  343-4 
Capital  in  service,  total  to  be  shown,  345 

"Last  cost,"  meaning  of,  356 
Definition,   341 

Indefinitenees  in  use  of  term,  433 

Items  entering  into,  341,  381  (See  also  "Construction") 
Replacements,  118,  303-4,  355 
Reproduction  (See  "Reproduction  cost") 

Coupon  bonds, 

Bearer  is  payee,  161 

Collection  of  interest  on,  161,  162 

Definition,   161-2 

Principal  and  interest  registered,   method  of,  165 

Registered,   163 

Registered  bonds  issued  in  exchange  for,   162 

Transfer  by  delivery,  161 

Ease  of,  causing  preference  for,  164 

Coupons,     (See  also  "Coupon  bonds") 

Detached  and  retained  by  corporations  as  method  of  registry,  163 

Interest  collected  by,  161-2 

Payable  to  bearer,  162 

Promissory  notes,  162 

Signature  of  corporation's  treasurer,  161 

Credit, 

Established,  regulation  to  protect,  330,  332 

Controlling    competition   for  purpose   of,   324    (See    "Existing    public   service 
enterprises") 

Required  revision  of  accounts  must  consider,  300 
Expansion  of,   effecting  development  of  corporation  finance,    12,  147-8 


INDEX 


473 


Credit — Continued 

Inflation  of,  through  stock  or  bond  issues,  57,  297-8  (See  "Overcapitalization") 

Effect  of  successive  sales  of  stock  at  inflated  values,  58,  298 
Interest  or   dividends,   default   in,   effects  compared,   401 
Investors  in,  bondholders  as,  12 
Of  corporation. 

Price  of  stock  issued  controlled  by,  72-3,  74 
Security    for   bonds,   consisting  of,    154 
Effecting  term  of  bonds,  231 

Creditors, 

Classes  of  stock  purporting  to  confer  rights  of,  lOO 

Debtors  and,  relation  between,  100 

Preferred  stockholders  not,  99-100 

Prohibition  of,  affecting  theory  of  capital  stock  issues,  56 

Stockholders,    no    recourse   against,    for   corporate   debts,    56    (See   also    "Limited 

liability") 
Exception  of  wages,  8,  56 

Cumulative  preferred  stock, 

Definition,    103 

Effect  on  subordinate  classes  of  stock,  103-4 

Past-due  dividends  not  interest-bearing,   103 

Cumulative  voting, 

To  give  minority  representation,  93-4 

Currency  bonds,  236 


Debenture  bonds. 

Definition  of,  use  in  England,   170,  203 
Secured  on  corporate  undertaking,   170,  203 

Debenture  income  bonds,  203 
Debenture  stock,  111,  204 
Debentures, 

General   use   to   denote   unsecured   issues,   202,   203 
Significance  of  term   as  used   in   England,  203 

Mortgage,  204 

Registered  or  to  bearer,  204 

Simple,  203 

Debt, 

Amortization  of   (See  "Amoitization  of  funded  debt") 
Capital  stock  not  a,  of  corporation,  32-3,  49,  54,  99-100,  152 
Classification  into  funded  and  unfunded,   149 

Basis  of,   term   in   years,   149-50 
Lien  of,  upon  property  of  corporation,   155  (See  also  "Liens") 
Permanency  of,  acquired  for  capital  purposes,  228-9,  236 
Power  of  corporation  to  contract  (See  "Borrowing  money") 

Declaration  of  dividends,     (See  also  "Dividends") 

Courts   loath   to   review   action  of   directors,   130 

Dates  for,  how  fixed,   146 

Directors  to  declare  formally,  112-3,  129 

From   surplus,  112-3 

Shareholders'   control  over,   in  other  countries,   112-3 

Stockholders'  right  to  demand,  1301 


474 


INDEX 


Default,     (See  also  "Bondholders:    remedies,"  and  "Remedies") 

Of  corporation  on  bond  agreement,  what  constitutes,  180 
Remedies  of  bondholders  to  be  exercised  upon,  166,  171 

Deficiency  judgment,  155 
Deficit, 

Capitalization  of,  not  allowed,  440-2 

Excepting  accrual  during  construction  period,   385,  440 

Definitive  bonds,  160 
Denomination  of  bonds, 

"Baby"  bonds,  154 
Considerations  controlling,  153-4 

Economy   of  handling,   153 

Marketability,  153-4 
"Face  value"  preferable  to  "par  value,"  153 
Par  value  as  measure  of  corporate  liability  on  bond,   152 
Registered   bonds,   154 
Translation   into  foreign   currency,   212 

Depreciation  of  fixed  capital, 

Accounting,  to  effect  even  distribution  of  costs,  354 

Neglect  of,  351 

Proper  treatment  important,  118,  119 
Accrued,  reserve  for,  accounting,  354 

Balance  sheet,  119,  354 
Accruing,  charge  to  operating  expenses,  351 

Instructions  for  accounting,  353-4 

Necessity  of  accounting  for  as  part  of  production  cost,  350 

Omission  of  formal  actounting,  argument  for,  352 
Amount   of,   important   to   determine   accurately,   351 

Detailed  accounting  of  fixed  capital  necessary  as  basis,  343-4 

Effect  of  errors  in  estimates,  352-3 

Method  of  ascertaining,  352,  354 
Definition,   350 
Expense   of,    defined,   353 
Intangible  capital,  359 
Nature  of,  118,  348-50,  353 

Rate  of,  considerations  to  control  determination  of,  354 
Relation  to  serial  bond  maturity,  193,  243-4 
Reserve  for,  mortgage  requirements,   172 

Development  expenses, 

Capitalization  for,  440 

Proper  charge  to  capital,   conditions   supporting,  385 

Directors, 

Authority  of,  to  manage  corporation,  12,  31,  84-5 

By-laws  to  regulate  acts  of,  85 

Cumulative  voting  for  election,  93-4 

Declare  dividends,  112-3,  129 

Judgment  of  value  of  property  acquired  conclusive,  301    (See  also  "Consideration 

realized  on  issue  of  securities") 
Misdemeanor  of,   to  permit  withdrawal  of  stockholders'  capital,  42 
Resolution   of,  authorizing  bond  issue,    incorporated  in  trust   deed,  158 
Right  to  elect  majority  of,  representing  preferment  in  control,  106 


INDEX  475 


Discount, 

Bonds  purchased  at,  accounting  for,  222-3 
Bonds   sold   at. 

Considerations  governing,  215-6 

Disadvantage  of  too  great  a  discount,  217-8 

Regulated  by  commission  fixing  price  of  issue,  218,  364 
Bonds,   suffered  on  sale  of, 

Accounting  for,  223-4,  226,  363 

Not  chargeable  to  capital  accounts,  362-3 

Opinions  holding  to  propriety  of  charging  capital,  363-4 

Cost  of  borrowing,  part  of,  216,   363 

Definition,  215,  362 

Expenses  of  issue  combined  with,  362 
Stock,  realized  on  sale  of, 

Accounting  for,  75-6 

Balance  sheet  to  show,  75 

Bond  discount  compared,  72 
Stock  sold  at. 

Authority  of  law  required  to  permit,  70-1 

Considerations  warranting,  70 

Preferable  to  bond  issue,  when,  73 

Regulated  by  commission  fixing  price  of  issue,  70-1 

Statutory  provision  limiting  :;mount,   Massachusetts,  70 

"Watered"  stock  distinguished  from,  70 

Discrimination, 

By  common  carriers,  15-6 

Free  service  to  municipalities  constituting,  369 

In  public  undertakings  prohibited,   15 

Dividend-on, 

Sale  of  stock  at,  146,  221 

Dividends, 

Amount  of,   expressed  as  per  cent  of  par,  72 

Bond,  135-8 

Capital  not  to  be  paid  out  as,  95,  113-4,  124 

Application  of  rule  where  capital  has  been  impaired,   124-6 

Exception  of  wasting  assets,  127-8 

What  constitutes  payment  out  of,  123-7 
Corporation  may  not   guarantee,   109 
Declaration  of  (See  "Declaration  of  dividends") 
Definition,  112,   137,  152-3 
Maintenance   of,   desirable,   115 
Ownership  vested  in  real  owner  of  stock,  47 
Payment, 

Borrowing  money  for,  132-3 

Dates  for,  146 

Mediums  used  for,   131-3 

Consideration  other  than  cash,  when  used,   132 
Right  of  preferred  stockholder  to  demand  cash,  132,  1J3 
Stockholder  may  not  choose,   132 
Property  distributed  as,  145-6 
Scrip,  133-5 

Stock,  138-145  (See  also  "Stock  dividends") 
Surplus  profits,  from,  112-3 

Proportion  to  be  divided,  127 


476  INDEX 

Dividends — Continued 

Yield,   net, 

Computation,   219-21 
Definition,    219-20 

Divisional  bonds,  185,  188 
Dock  bonds,  188 
Domestic  corporations, 

Nature  of  jurisdiction  over,  of  incorporating  state,  27-6,  284  (See  also  "Regulation 
of  stock  and  bond  issues") 

Domicile, 

Corporation's,  149 
Of  bonds,  212 
Of   shares,   S2 

Duplication  of  plants,     (See  also  "Competition") 

Incident  of  competition   in  public  utility  enterprises,  308 
Results  of  duplicating  investment,  308,  312 
Usually  followed  by  consolidation  or  merger  of  competitors,  308 

Purpose  of  regulation  to  prevent,  312 

Earning  power. 

Index  of  value  of  corporate  assets,  74,  299 

Valuations  based  on,  impracticable  for  accounting  purposes,  337-8 

Ecclesiastical  corporations,  6,  7 

Eleemosynary  corporations,  6,  7 

Eminent  domain  (See  "Condemnation,  power  of") 

England, 

Companies  Act  (See  subhead  below,  "Prospectus") 
"Debenture,"  meaning  with  which  used,  203-4 
Prospectus  Act,  63-4,  65 

Urged  for  adoption  in  the  United  States,  65,  69 
"Shares"  and  "stock,"  meaning  with  which  used.  111,  204 

Equipment  bonds,     (See  also  "Equipment  obligations") 

Conditional  sales  as  basis  of  security,  194 

Definition,  192,  193 

Trustee,  title  vested  in,  194-5 

Equipment  obligations. 

Characteristics  of,   affected  by  nature  of  property  by  which  secured,   192-3 

Classification  of,   193 

Definition,  192 

Lien  of,  how  enforced,   196-7 

Purpose  of  issue,  192 

Security  for,  basis  of,  197-8 

Serial  maturity,  193  (See  also  "Serial  maturity") 

Equipment  trust  certificates, 

Definition,  192,  195 

Earliest  form  of  equipment  obligations,  195 

Guarantee  of  a  railroad  corporation  supporting,   196 

Interest  in  unincorporated  association,  represented  by,  19S,  196 

Security  for,  195 


INDEX 


477 


Equity, 

Stockholders',  in  corporate  assets,  54,  76  (See  also  "Stockholders:  proprietorship") 
Trading  on  the,  147,  237,  255 

"Ex-dividend," 

Sale  of  stock  at,  146 
Existing  public  service  enterprises. 

Investors  in,  protected,  324 

Occupation  of  territory  by,  what  constitutes,  315-6 

Protection  from  competition,  entitled  to,  309,  314 

Basis  of  right,  readiness  and  ability  to  serve,  309,  314,  316-7 
Necessary   incident   of  regulation,  310,   314 
Duty  of  public  to  assure,  22 
Right  may  be  lost,  316 

Defaults   must   be   serious   to   cause,   317 
Indifferent  service  will  warrant,  316-7 

Merits  of  competitor  to  be  examined,  317-8  (See  "New  public  service  en- 
terprises") 

Express  powers  of  corporations,  11 
Extension  bonds,  185,  188 
Extra-long-term  bonds,  229 

F 

Federal  incorporation. 

Companies   existing   under,   9 

General   laws   for,   proposed,   9 

Relation  to  federal  regulation  of  capitalization,  273 

Federal  regulation  (See  "Interstate  Commerce  Commission") 

Federal  Trade  Commission, 

Creation  of,  29 
Powers   of,   29-30 

Ferry  bonds,  188 

Finance,  corporate,    (See  "Corporation  finance") 

Financial  condition  of  corporation. 

Bearing  upon  proposed  capitalization,  303-4 

Overcapitalization  alleged  to  exist,  294   (See  also  "Overcapitalization") 
Misrepresentation  of,  by  accounting,   115-6,  298,  301 

First  lien  bonds,  199 
First  mortgage  bonds. 

Definition,  186,  198-9 

Lien  of,  185 

Subject  to  prior  liens,  199 

Fixed  capital. 

Accounting  for,  bases  of,  336-7 

Capital  withdrawn  to  be  credited,  345-8 

Instructions   for,   348 
Cost  as  basis  of,  11,  119,  337,  340-1  (See  also  "Cost") 
Detail  to  be  shown,  343 

Restatement  necessary  if  original  detail  insufficient,  343-5 
Importance  of  proper,  118,  119-20,  337 


478 


INDEX 


Fixed  capital — Continued 

Accounting  for,  bases  of, — Continued 

Operating  expenses,  charges  to,  when  made,  129-30,  336-7 

Correction  required  if  capitalization  sought  to  reimburse,  428 
"Secret  reserves,"  created  by,  336 
Reproduction  cost  as  basis   of,   337-9   (See  also   "Reproduction  cost") 

Valuations  to  be  used  as  basis  of,  337  (See  also  "Valuations") 
Difficulty  of  recording,  119,  339-40,  341-3,  435 
Additions  to,  defined,  345 
Balance  sheet,  disposition  of,  336 
Betterments  of,  defined,  345 
"Book  value,"  118-120 
Capitalization  for  purposes  of,  358  (See  also  "Intangible  capital,"  and  "Tangible 

capital") 
Classification,  into  landed  and  non-landed  capital,  358 
Classification,  into  tangible  and  intangible,  358 
Consumption  of,  in  productive  process,  353 

Compared  with  floating  capital,  335,  348 
Definition,  335 

Depreciating  nature  of,  348,  349,  353 
Floating  capital  distinguished  from,  118,  267,  335 

Confusion  in  accounts  may  produce  overcapitalization,  267 
Inadequacy  of,  entering  into  depreciation,  350 
Intangible  (See  "Intangible  capital") 
Landed,  358 
Non-landed,  358 

Obsolescence  of,  entering  into  depreciation,  350 

Reimbursing  income  for  moneys  expended  on,  426  (See  also  "Reimbursement") 
Replacements  of,  355  (See  also  "Replacements") 
Sale  of,  accounting  for  proceeds,  119 

Authorization  of  commission  required,  26 
Tangible  (See  "Tangible  capital") 
Value  of,  test,  339 

Wear  and  tear  (See  "Depreciation,"  and  "Maintenance") 
Withdrawals  or  retirements  of,  345-8 

Floating  capital. 

Definition,  335-6 

Expense  of  operation,  336 

Fixed  capital  distinguished  from,  118,  335 

Confusion  may  produce  overcapitalization,  267 
Nature  of,  267 

Floating  debt, 

Definition,  443 

Funding  of  (See  "Funding  operations") 
Foreclosure,     (See   also   "Reorganization,"   and   "Remedies    of   bond- 
holders") 
Basis  of  right  to  proceed  on,  181 
Decree  of,  182 

Desirable  to  avoid,  because  of  public  policy,  168,  183 
Insufficient  proceeds,  judgment  for  deficiency,  156 
Receivership  pending,  181-2 
Sale  under,  166,  182 

Foreign  corporations, 

Jurisdiction  of  state  over  police  power  as  basis,  281-2 
Rule  as  to  interstate  corporation,  283 


INDEX 
Foreign    Corporations! — Continued 

Limited  rights  in  other  states,   necessitating  subsidiaries,  397-9 
Case  of  holding  companies,  411 
State  control  made  less  effective,  398 

Forfeiture  of  stock, 

For  non-payment  of  subscriptions,  43 

Founders'  shares,  110-11,  366 
France, 

Statutory  control  of  overcapitalization,  62 

Franchises, 

Classification  of,  into  general  and  special,  367-8 

Of  associates  to  exist  as  corporation,  367  (See  also  "General  franchise") 

To  occupy  streets,  etc.,  368  (See  also  "Special  franchises") 

Full-paid  stock, 

Definition,  42 

Status  as,  of  stock  sold  at  discount,  70 

Funded  debt, 

Amortization  of,  237-8  (See  also  "Amortization  of  funded  debt") 

Certificates  of,  bonds  constitute,  152 

Classification,  secured  and  unsecured,  154-5 

Definition,  149 

Discharge  of,  provision  for  payment  on  maturity,  159 

Payment  of  bonds  distinguished  from  discharge  of  debt,  228 
Issue  of,  to  be  authorized  by  commission,  150 
Matured,  classified  as  unfunded,  149-50 

Redemption  of  bonds  included  in  (See  "Redemption  of  bonds") 
.Refunding  of  bonds  included  in  (See  "Refunding  operations") 
Secured,  defined,  154 

Security  for,  154  (See  also  "Security  for  funded  debt") 
Unfunded  debt  distinguished  from,  149 

Funding  operations, 

Capitalization  incident  to,  authority  for,  442 
Purposes  must  have  been  proper,  445-6 
Bond  interest,  special  case  of,  446-9 
Distinguished  from  "refunding  operations,"  442-3 

Future  acquired  property. 

Covered  by  existing  mortgage,  166-7 

Attempts  to  defer  lien  from  attaching,  167 
Situation  of  individual  distinguished  from  that  of  corporation,  167 

G 

General  and  first  mortgage,  200 
General  franchise. 

Amendment  of,  right  of  state  to  make,  11,  278-9 

Assignment  of,  3,  368 

Capitalization  of  beyond  amount  of  cost  not  permissible,  360-1 

Cost  of,  as  intangible  capital,  360  (See  also  "Organization  expenses") 

Prohibition  against  inclusion  in  capital,  Europe,  360 
Definition,  367-8 
Grant  of,  1 


479 


480  INDEX 

General  franchise — Continued 

Not   subject   to   mortgage,   166 

Not  subject  to  sale,  3,  368 

Property  of  members  and  not  of  corporation,  3,  360,  767 

Application  of,  to  accounting  in  European  countries,  360 
Revocation  of,  3,  9 

Right  of  state  to  cause,  9 
Surrender  of,  3 

General  first  mortgage  bonds,  200 
General  laws,  incorporation  under. 

Articles  of  association  to  be  filed,  11 

Corporation  created  by  filing,  11 

Where  filed,  11 
Charter  of  corporation,   what  constitutes,   11 
Constitutional  provision.  New  York,  in  respect  of,  11 
Development  of  method,  10-11 

General  Mortgage, 

Order  of  liens,   186,  200 
I'urpose  of  issue,  200 

Gold  bonds,  187,  235 
Good-will,  378 
Guarantee, 

Bonds  of  subsidiary  corporation,  206  (See  also  "Reinforced  security") 
Dividends,  by  corporation  issuing  the  stock,   101 

Guaranteed  bonds,  187,  206 
Guardianship, 

As  position  of  commission  in  relation  to  investors,  299,  329 

H 

Holding  companies,     (See  also  "Controlling  corporations"  and  "In- 
tercorporate relationships") 

Definition,  411 

Financing  of,  412 

Jurisdiction  of  commissions  over,  413 

Purpose  of  organization,  411 

I 

Impairment  of  capital. 

Effect   upon  right  to  distribute  profits  of  later  period,   123-7 
Restraints  on;  capital  stock  reacquired  out  of  surplus  profits,  etc.,  95 
Dividends  to  be  paid  out  of  profits  only,  113-4,  124 

Impairment  of  contracts. 

States  prohibited  from  passing  laws  causing,  296 
Effect  on  corporate  charts,  278-9 
Relation  to  remedy  of  scaling  down  outstanding  securities,  296 

Implied  powers  of  corporation, 

Definition,  11 
Enumeration  of,  11-12 


INDEX  481 

Improvement  bonds,  186,  188 
Improvement  or  maintenance  of  service, 

Capitalization  of  expenditures  for,  393,  438-40 

Incidental  powers  (See  "Implied  powers") 
Income, 

Account,  construction  of,  117 

Items  included  in,  118 
Appropriations  for  fixed  capital  investment,  129-30,  336-7 

Accounting,  129 

Capitalization,  426  (See  also  "Reimbursement") 
From  investments  (See  "Investment  income") 
Mortgage,  when  subject  to  lien  of,  166 
Net  corporate,  or  loss,  117 
Pledged  to  secure  payment  of  bond  interest,  166  (See  "Income  bonds") 

Income  bonds, 

Definition,  202,  203 

Interest  on,  secured  by  pledge  of  income,  166 

Security  for,  second  mortgage,  203 

Sold  "flat,"  221 

Incorporation,    (See  also  "Charter") 

Act  of,  what  constitutes,  8 

Date  of,  under  general  laws,  11 

Federal,  9 

Individuals  alone  cannot  effect,  3 

Object  of,  must  be  legal,  9 

State,  general  laws  for,  10-11 

State,  special  acts  of  (See  "Special  act") 

Incorporators, 

Corporations  as,  3,  94 

Must  be  natural  persons,  1,  2,  3,  94 

Indifference  of  stockholders. 

Abuses  in  proxy  system  due  to,  87 
Minority  may  control  because  of,  89-90 

Indorsed  bonds,  206 
Indorsement  in  blank. 

On  certificate  of  stock,  effect  of,  46-7 

Negotiability  effected,  49 
On  registered  bonds,  effect  of,  162 

Intangible  capital. 

Capitalization  for  acquisition  of,  358 

Classification  of,   165-6,  358-9 

Contracts  rights  as,  358,  374 

Definition,  358 

Depreciation  of,  359 

Franchise  as,  358,  367  (See  also  "Special  franchfses") 

Good-will  as,  378 

Mortgage  on,  165 

Nature  of,  358-9 

Organization  expenses  as,  358,  359 

Patent  rights  as,  358,  374 


482 


INDEX 


Interchangeable  bonds,  162 

Intercorporate   relationships,     (See   also  "Controlling  corporations,' 
and  "Holding  companies") 

Complexity  of,  396-7 

Creation  of,  by  stock  ownership  (See  "Acquisition") 

Dangers  of,  through  improper  financing  operations,  399 

Definitions,  394 

Financial  results  of,  generally,  399-401   (See  also  "Collateral  bonds") 

Jurisdiction  of  commission  over  crc-ation  of,  26 

Necessity  for,  by  reason  of  limitation  of  state  laws,  397-8 

Regulations  of,  by  commissions,  27 

Public  policy  to  be  considered,  404 
Relationship  which  should  exist  between  projects  of,  405-6 
Restrictions  on  the  creation  of,  396 

By  federal  statute,  29 

Interdepartmental  accounts, 

Proper  and  improper  uses  of,  122 

Interest-bearing  stock,  109-10 
Interest  income. 

Net  rate  of,  to  bondholder,  215 

Interest  on  funded  debt, 

Accrued,  added  to  price  of  sale,  220-21 

Actual  cost  of  (See  subhead  below,  "Effective  rate  of") 

Collection  by  coupon,  162 

Definition,  152,  210 

Eflective  rate  of,  214-5 

Amount  of  consideration  realized  on  issue  of  bond  controlling,  214-5,  216-7 

Risk  of  enterprise  affecting,  211,  216 

Statutory  regulation  of,  214,  218 
Fixed  charge,  149 

"Interest  deductions  for  funded  debt,"  text  of  account,  226 
Nominal  rate  of,   213-4 

Considerations  afifecting  determination  of,  213-4,  217 

Issues  with  different,  213 

Risk  of  enterprise  affecting,  211 

Statutory  limitation  on,  214 
Payment  of,  contingent  on  earning,  153  (See  also  "Income  bonds") 

Dates  for,  211 

Considerations  influencing  choice  of,  212 

Default  in,  matures  pricipal,  153,  156 

Direct  to  registered  bondholder,  164 

Medium  of,  159,  227 

Presentation  of  coupon,  162 

Where  made,  212 

Without  deduction  for  taxes,  160,  208-9 
Rate  of  (See  subheads  above,  "Effective  rate  of,"  and  "Nominal  rate  of") 

Compared  with  rate  of  dividends,  210 

Statutory,  214,  218 
Secured  in  like  manner  as  principal  of  debt,  159-60 

By  pledge  of  income,  166 

Interest  warrants  (Sec  "Coupons") 


INDEX 


483 


Interest  yield,  net, 

Computation  of,  221-3 

Definition,  219-20 

Effect  on  bond  values,  216 

Interminable  bonds,  229 
Interstate  commerce. 

Clause  in  United  States  Constitution,  28-9 

Corporations,  right  to  do  business  in  other  than  parent  state,  283 

Regulation  by  states  under  exercise  of  police  power,  278 
Power  of  Congress  over,  9,  28 
Right  to  carry  on,  under  United   States   Constitution,  283 

Interstate  Commerce  Commission, 

Authority  for  creation  of  as  a  federal  regulatory  body,  29 

Creation  by  Congress,  29 

Direct  control  over  capitalization, 

Agitation  for,  270,  272 

Attitude  of  Commission  toward  extension  of  its  power  to  include,  271-2 

Federal  incorporation  an  aid  to,  273 

Limitations  of  state  authority  an  argument  for,  270-1,  281 

Railroad  Securities  Commission,  report  against,  272 

Relation  to  state  jurisdiction,  273 
Indirect  control  over  capitalization,  269-70,  299-300 
Jurisdiction  primarily  over  the  interstate   commerce,   28 
Physical  valuation  of  railroads  by,  252,  270,  414,  433-5 
Powers  of,  29,  299-300 

Investment  income. 

Net  rate  of,  defined,  219-221 

Net  dividend,  and  net  interest,  yield;  classification,  219 

Investments, 

In  new  enterprises,  to  be  encouraged,  330 

Discouraged  by  indiscriminate  attacks  on  corporations,  331 
Of  public  service  corporations  in  plant,  etc., 

Amount  of  actual,  compared  with  capitalization,  268 

Property  not  used  for  public  service  to  be  acquired  out  of  surplus,  405,  414 

Relation  to  rates,  268,  323 

Safeguarding  of,  purpose  of  regulation,  324 
Of  public  service  corporations  in  stocks,  etc.. 

Subsidiary  companies  (See  "Acquisition") 
Valuation,  120 

Unrelated  companies,  acquired  from  surplus  funds,  405,  414 

Investors, 

In  outstanding  securities,  protection  of  interests,  334 

In  securities  authorized  for  issue,  responsibility  towards,  generally,  325 

Commission  not  charged  with  duty  of  preventing  unwise  investments,  339-30 

Guardianship,  concept  of,  in  court  decisions,  299,  329 

Investment  value  of  authorized  securities  not  vouched  for,  336 

No  guaranty  extended  by  state  to,  325-6 

Right  to  rely  on  commission's  findings,  326-8 
Regulation  for  benefit  of,  68-9 

Inventory, 

Of  materials  and  supplies,  121 
Method  of  constructing  balance  sheet,  115 
Limitations  on,  115-6 


484  INDEX 

Irredeemable  bonds. 

Contingent  maturity  on  default  of  interest,  153 

Limited  use  of,  228,  229 

Theory  of  loan  capital  supporting,  228 

Issue, 

"Actual"  and  "nominal,"  38-39 

Of  stocks  and  bonds  to  be  authorized  by  commission   (See  "Regulation  of  stock 
and  bond  issues") 

Capital  to  be  secured  by,  290 

Penalties  for  unauthorized  issue,  275 


"Joint-Stock  associations. 

Articles  of  association,  5 

Capital  stock  of,   divided   into   shares,   5 

No  par  value  assigned,  6 
Corporations  distinguished  from,  5 
Definition,  4-5 

Variety  of  meanings  assigned,  3 
Early  form  of,  3-4 

Examples  of  companies  now  operating  as,  5-6 
Liability  of  members  as  partners,  5 
Organization   under  common   law   or  statute,   5 
Place  of,  in  development  of  business,  12 

Junior  bonds,  199 

L 

Land, 

Value  of,  apart  from  operations  of  railroad,  169 

Landed  capital,  358 
Land-grant  bonds,  187-8 
Leases, 

Contracts  of,  not  to  be  capitalized,  375 

Legal  investments, 

In  relation  to  fixing  proportion  of  bonds  to  stock,  266 
Market  for  unsecured  funded  debt  affected  by,  155 
What  constitutes,  in  New  York,  266 

Legal  tender  bonds,  187,  236 
Liens, 

Creation  of,  as  security  for  debt,  155 

By  mortgage  or  pledge,  155  (See  also  "Mortgage,"  and  "Pledge") 

Regulation  by  state,  280,  285 
Enforcement  of,  for  satisfaction  of  the  debt  (See  "Foreclosure,"  and  "Remedies  of 

bondholders") 
Multiplicity  of,  not  favored,  199 

Bond  issues  intended  to  unify,  199-201 
Ranking  order  of,  198-202 

Bonds,  classified  on  basis  of,  186,  198-9 

Determination  of,  essential  to  appraisal  of  security,  198 


INDEX  485 


Limited  liability, 

Attribute  of  capital   stock,  8,    12,   31,   56 
Effect  on  general  creditors,  148 

No  recourse  against  stockholders,  56 
Joint-stock  association,   liability  of  members  compared,  5 
Partners,  liabilities  of,  compared,  8,  12,  99 
Par  value,  measure  of,  56 

Loan  capital, 

Authority  for,  148-9  (See  also  "Borrowing  money") 

Definition,  148 

Division  into  small  units  (See  "Denomination  of  bonds") 

Integrity  of,  necessary  to  be  maintained,  56,  148 

Investors  in,  154,  210 

Share  capital  distinguished  from,  148 

Stockholders'  relation  to  (See  "Trading  on  the  equity") 

Long-term  bonds,  186,  230-1 
Lot, 

Drawing  of  bonds  by,  234 

M 
Maintenance  of  fixed  capital. 

Capital  charges  not  to  be  included  in  expenses  of,  35S 

Classification  of  charges,  350 

Deferred  (See  "Depreciation") 

Definition,  349 

Depreciation  and,  349 

Even  distribution  of  costs,  depreciation  accounting  to  give,  354 

Imperative  maintenance,  350-1 

Importance  of  proper  accounting,  350 

Mortgage  requirements  for  adequate  provision,  173 

Optional  maintenance,  350 

Results  of  postponing,  353 
Overstatement,  in  accounts,  355 
Repairs  constituting,  distinguished  from  replacement,  355 

Definition,  355 
Understatement,  in  accounts,  355 

Operating  expenses  carried  in  suspense,  355 
When  justifiable,  355 

Maintenance  or  improvement  of  service, 

Capitalization  for,  393,  438-40 

Deficits,  capitalization  of,  distinguished,  440 

Majority  control. 

General  rule  in  all  associations,  89 

Limitation  upon,  to  provide  for  minority  representation,  92 

Cumulative  voting  by,  93-4 

Limiting  vote  cast  by  any  one  stockholder,  93 

Restricting  number  of  directors  voted  for  by  majority,  93 
Number  of  votes  required  to  authorize  acts  of  corporation,  90 
Proportion  of  stock  required  to  constitute,  89-90,  394-6 

Number  of  stockholders  affecting,  89,  90 
Special  responsibility  of,  to  minority,  91-2 

Failure  to  recognize,  reason  for  minority  representation,  93 


486 


INDEX 


Market  psychology. 

Issue  of  bonds  at  discount  due  to,  217 
Proportion  of  bonds  to  stock,  effect  on,  265-6 

Market  value  of — 

Bonds,  attempt  to  uphold  by  limiting  issue,  191-2 

Causes  producing  enhancement,  216 
Stock,  basis  of,  72 

Controlling  price  of  issue,  72-3,  75 

Reflecting  adequacy  of  rates  charged  by  corporation,  73 

Materials  and  supplies, 

Inventory  value  of,  121 

Maturity  of  bonds, 

Bonds   having   no,   153 

Effect  on  classification  of  debt,  149-50 

Payment  upon  (See  "Payment:  bonds  matured") 

Meeting  of  stockholders. 

Quorum  at,  by-laws  to  prescribe,  90 
Vote  of  majority  present  will  enact,  90 

Exceptions  by  statute  in  specific  acts,  90 

Membership  corporations. 

Classification  of,  7 

Definition,  7 

Non-stock  corporations  as,  6,  7 

Merger, 

Capitalization  of  merging  company,  extent  to  which  aflfected,  418 

Contract  of,  not  subject  to  capitalization,  375 

Definition,  417 

Jurisdiction  of  commission,  419 

Anti-trust  laws,  application,  419 
Public  policy  to  control,  332 

Minority  representation, 

Cumulative  voting,  93 

Limiting  number  of  directors  elected  by  majority,  93 

Necessity  of  providing  for,  93 

Special   duties   owing  to,   by  majority,   91-2 

Misdemeanor, 

False  statements  or  representations  before  commission,  275 

Mortgage, 

Authority  to  execute,  280,  285  (See  also  "Liens") 

Bond  and,  defined,  156 

Bond,  definition,  188 

Bond  essential  to  existence  of,  156,  159 

"Closed,"  160 

Conveyance  of  title,  155-6,  167 

Corporation  executes,  156-7  (See  also  "Trust  deed") 

Definition,  155 

Foreclosure  of  (See  "Foreclosure") 

Franchises  subject  to,   165-6 

Income,  when  subject  to,  166 

Issue  of  additional  bonds,  restricted  by  provisions  of,  172-3 

Lien  of,  deferred,  167 

Enforcement  for  satisfaction  of  debt,  180  (See  also  "Liens") 


INDEX 


487 


Mortgage — Continued 

"Open,"  160 

"Open-end,"  160 

Patent  rights  subject  to,  166 

Power  to   subject  property  to,   laws   governing,   157 

Limitations  of  public  service  corporations,  157 
Property  subject  to,  generally,  165 

As  basis  of  classifying  bond  issues,  185-6 

Effect  on   characteristics   of  bonds,   193,   231,  245,   250  (See  also   "Equipment 
obligations") 

Indication  of,  in  bond  titles,  185 

Owned  or  thereafter  acquired,  166-7 

Personal  property,  155,  165 

Realty  alone,  155,  165,  187 

Personalty  usually  also  included,   155,   165 

Tangible  or  intangible,  165  6 
Ranking  order  of  lien  classifying:  first,  second,  etc.,  186,   199 
Record  and  filing  of,  157,  165 
Validity  of,  laws  of  state  governing,  157,  280 

Municipal  aid, 

Extended  to  railroads,  313 

Prohibited  in   New   York,  313 

Municipal  corporations,  6,  7 

N 
Natural  monopoly, 

Characteristics  of,  19-20 

Public  service  corporations  as,  25 

Natural  persons. 

Association  of,  required  to  organize  a  corporation,  1,  2,  3,  94 
Powers  of,  compared  with  powers  of  corporations,  1 

Negotiable  instruments. 

Bonds  as,  152,  163-4 
Certificates  of  stock  as,  49 
Characteristics  of,  49,  163-4 

Net  corporate  income, 

Definition,  117 

Net  dividend  yield. 

Computation,  220-1 
Definition,  219-20 

Net  earnings. 

Definition,  1234 

Net  interest  yield. 

Computation,  221-2 
Definition,  219,  221 

New  public  service  enterprises. 

Admission    into    competition   regulated,   22,   26,   308-9 

Existing   corporation   entitled   to   protection   against   competition   of,   309,   314   (See 
also  "Existing  enterprises") 
Loss  of  right,  316 


488  INDEX 

New  public  service  enterprises — Continued 

Existing    corporation    entitled    to    protection    against    competition    of — Continued 
Situation  of  proposed  competitor  to  be  considered  on  affirmative  proof,  318 
Financial  ability  to  be  considered,  318-9 
Lower  rate  proposals  not  sufficient,  317-8 
Popular  desire  for  competition  not  controlling,  317 
Operation  in  new  territory,  commission  to  authorize,  26,  312 
Financial  resources  of  applicant  to  be  considered,  318-9 

Regulation  to  prevent  bankrupt  enterprises,  328 
Popular  desire  not  controlling,  313-4,  331 
Willingness  of  investors  to  engage  in,  not  controlling,  313 
Special  act,  incorporation  under,  as  means  of  regulating,  23,  309 
Territory,  contest  for,  314-6 

Nominal  issue,  39 
Nominative  shares,  50 
Non-cumulative  preferred  stock. 

Definition,    103 

Interest  of  common  stock  may  adversely  affect,  104 

Non-landed  capital. 

Definition,  358 

Non-participating  preferred  stock. 

Definition,  101 

Non-stock  corporations,  6,  7 
Notes,  corporate, 

Bonds,  compared  with,  152 
Definition,  152,  202 

Demand  for,  as  incentive  to  use  of,  233 

Maturity  in  less  than  year,  issue  not  regulated,  150,  232,  443 
Purpose  of  exemption,  443 
Renewals,  limitations  on,  150,  232,  444 

Longer  term  bonds  or  notes,  (See  "Funding  operations") 
Use  of,  to  avoid  jurisdiction  of  commission,  232,  443 
Attempts  to  be  discouraged,  443-4 
Responsibility  of  commission  for,  232,  444 
Maturity  in  more  than  year,  issue  regulated,  27  (See  also  "Bonds,"  "Regulation  of 

stock  and  bond  issues") 
Purpose  of  short-term  issues,  temporary  aid,  231 

Tentative  financing,  pending  market  improvement,  231-2 
Conditions  governing  economical  use  of,  232 
Short-term  bonds  and,  definitions,  186 
Unsecured  by  lien  on  property,  usual  condition,  152,  202 
Validity  of  laws  of  state  governing,  149 

o 

"Open-end"  mortgage,  160 
"Open"  mortgage,  160 
Operating  expenses, 

Capitalization  to  provide  for  (See  "Maintenance  or  improvement  of  service,"  and 
"Working  capital") 
"In  general  grossly  offensive,"  439 
Manipulation  of,  affecting  surplus,  121 
Suspension  of,  122 


INDEX  489 

Optional  bonds,  186,  233,  234 
Organization  expenses. 

Capital  charge,  360 

Excluded  from,  by  German  and  Swiss  laws,  360 
Capitalization  of,  359,  367 

V^aluations  other  than  cost  not  allowed  as  basis,  361 
Intangible  capital  included  in,  358-9 
Items  included  in,  generally,  359 

Corporate   organization   expenses,   361-2 
Financing  expenses,  362 

Bond  issue,  for  capitalization  purposes,  364 

Accounting  for  (See  "Discount:  bonds,  suffered  on  issue  of") 
Stock  issue,  362 
Promoters'  fees,  364  (See  also  "Promoters'  fees") 
Taxes  paid  on  organization,  361 

Overcapitalization, 

Causes  producing,  267,  303-4 

Circumstances  at  time  of  issue  to  be  known  before  condemning,  301-2,  305-7 

Definition,  58,  296-7 

Dissimilarity  of  meanings,  297 
Effect  on  additional  capitalization,  294-5 

Need  not  be  a  bar  to,  301  (See  also  subhead  below,  "Remedies") 
Inflation  of  credit  supposed  to  be  produced  by,  57 

Different  results  of  stock  or  bond  issues,  297-8 
Misstatement  of  accounts,  incident  of,  298,  301 
Rates  for  service,  relation  to,  64,  65 
Remedies,  omission  of  par  value,  81 

Regulation  of  accounts  as,  299 

Scaling  down  securities,  295-6,  299 

Overlying  bonds,  199 


Participating  preferred  stock. 

Definition,    101 

Rate  of  dividends,   101-2 

Terms  of  participation,  101-2 

Partnerships, 

Alleged  relation  between  public  service  corporations  and  public,  21-2 
Corporations  and,  distinguished,  12 
Interests  of  members  in,  96 
Joint-stock  associations  as,  4,  5,  6 
Liability  of  members,  8,   12,  96 

Compared  with  that  of  stockholders,  8,  12 

Similar  liability  in  joint-stock  associations,  5 
Limitations  of,  a  factor  in  development  of  corporations,  3,  12 
Place  of,  in  development  of  business,  12 
Stockholders,  relationship  between  themselves  that  of,  96,  99-100 

Part-paid  stock, 

Agreement   of  subscription  under,  42,  43,  44 
Issue  for  insufficient  consideration,  effect,  57,  71 

Liability  of  holders,  42,  71    (See  also   "Watered  stock") 

New   York   rule,   57 


490 


INDEX 


Par  value. 

Amount  of,  36 

Balance   sheet,    capital    stock   appearing   at,    55 

Capital  stock  to  be  issued  at,  general  rule,  54 

To  avoid  inflation,   57 
Corporate  financial  responsibility,  measured  by,  55 
Issue  of  stock  at  less  than,  34-5 

Forfeiture    of    charter    for,    57 

Liability  of  purchaser,   56 
New  York  rule,  57 
Misconception   of   meaning  of,   72 
Necessity  of,  stock  preferred  as  to  assets,  55 
Price  of  issue  to  be,  general  rules,  34,  41,  54 

Deviations   from,   34    (See   also   "Discount:    stock   sold   at,"   and   "Premium: 
stock  sold  at") 
Purpose  of  assigning  a,  32,  36,  81 
Real  value  distinguished  from,  64-5,  72,  76-8,  298 
Record  of  stockholders'  investment,  55 
Relation  to  increase  in  amount  of  proprietorship,  55 
Shares  without,  36,   78-83   (See  also  "Shares  without   par  value") 
Significance   of,   54-8 

Stockholders'  contribution  to  capital,  measured  in  terms  of,  41,  55 
Stockholders'  equity,  reference  to,  54 
Stockholders'  liability  limited  to,  57 
Trust  fund  theory,  application,  55-6 
Watered  stock  sold  for  less  than,  58  (See  also  "Watered  stock") 

Patent  rights, 

Accounting  for  cost  of,  374 

Capitalization  of,  374 

Mortgage,  subject  to  lien  of,  166 

Payment, 

Bond  interest  (See  "Interest") 
Bonds  matured,  amount  of  face  value,  152-3 
Deduction  for  taxes,  without,  160 
Medium  of,  classification  according  to,  187 

Gold  coin,  159,  235 

Legal  tender  and  currency,  236 

Purchasing  power  of  money  in  relation  to,  236 

Silver,  236 
Bonds  prior  to  maturity  (See  "Redemption  of  bonds") 
Dividends  (See  "Dividends") 

Permanent  debt    (See  "Funded  debt") 
Personal  enterprises, 

Corporate  project  as,  of  stockholders,  2,  31 
Place  in  development  of  business,  12 

Personal  interest, 

Of  stockholder,  affecting  relations  with  corporation,  42 

Elimination  of,  in  valuing  property  sold  to  corporation,  62-3 
Necessary  to  safeguard  corporate  welfare,  87 

Personal  property, 

Bonds  as,  206 

Bonds  secured  by,  classification,  186,  188  (See  also  "Collateral  bonds,"  and  "Equip- 
irent  obligations") 


INDEX 
Personal  property — Continued 

Chattel  mortgage  on,  155,  165 

Pledge  of,  155 

Real  estate  mortgage,  when  included  in,  165 

Real  property  distinguished  from,  165 

Shares  of  stock  as,  47,  51 

What  constitutes,  165 

Physical  valuation  of  railroads, 

Conducted  by  Interstate  Commerce  Commission,  252,  270,  414,  433-5 
Limiting  capitalization  to,  69,  151,  296,  302 

Plain  bonds,  202 

Plant     (See  "Fixed  capital") 

Pledge, 

Chattel  mortgage  distinguished  from,  155 

Definition,  155 

Of  securities  deposited  as  collateral,  179 

Police  power  of  state, 

In  regulation  of  foreign  corporations,  26,  278,  282 

Popular  desire. 

Commission  not  to  be  influenced  by  in  regulation,  282,  331 

Powers  of  corporation. 

Definition,  11 
Express,  11 
General,  1,  8,  11 
Implied,  11-13 

Preferred  stock, 

Assets  of  corporation  upon  dissolution,  equal  rights  of  shares,  98 

Preference  given  by  agreement  on  statute,  96,  99 

Shares  required  to  carry  par  value  if  so  preferred,  55,  80,  99 
Terms  of,  99 
Authority  for  creation  of  (See  "Capital  stock:  classification") 
Callable,  108,  221 
Classes  of,  first,  second,  etc.,  98 
Convertible,  107 
Cumulative,  103 
Debt  of  corporation,  not  a,  99,  100 

Special  classes  resembling,  100 
Definition,  93 

Divergent  interests  introduced  because  of,  105 
Diversion  of  dividends,  remedy  of  stockholders,  103 
Dividends, 

Attribute  of  preference  in,  101 

Participation  in  profits  beyond  preferred  rate,  101-2 

Past-due  dividends,  claim  on,  103 

Rates    of,    101,    102 

Terms  of  preference,  101 
Financing  by  bonds  or,  98,  102-3,  107 
Lien  of,  none  granted,  99 

Special  classes  purporting  to  carry,  100 
Non-cumulative,  103 
Non-participating,  101 
Participating,  101 


491 


492 


INDEX 


Preferred  stock — Continued 

Preferences,  conditions  described  in  charter  or  by-laws,  37,  97 
Kinds  of,  96-7 
Order  of,  98 
Priority    over    subsequent   mortgages,    Maryland   special   stock,    100 
Redeemable,    100,   108,   221 
Sole  outstanding  issue,  97 
Voting  rights. 

Limitation  upon  in  favor  of  common  stock,  106-7 
Reason  for,  107 
Waiver  conditional,   106-7 
Preference  in,  not  necessary  incident  of,  105 

Common  stockholders  relinquish-  in  favor  of,  105 

Reason  for,   105-6 
Nature  of  preferences,  105-6 

Premium, 

Bonds,  realized  on  sale  of. 

Accounting  for,  234-6 

Interest  to  be  paid  offset  by,  216 
Bonds  sold  at,  considerations  governing,  216 
Stock,  realized  on  sale  of. 

Accounting  for,  7S-6 

Permanent  reserve,  74,  75 

Significance  of,  74 
Stock  sold  at,  considerations  governing,  74 

Price  of  issue. 

Commissions  to  prescribe  minimum. 

Bonds,  218,  364 

Stock,  70-1 
Market  values  in  relation  to,  70-1,  72-3,  75 

Competition  of  capital  affecting,  214 
Regulation  of,  experiments  of  Massachusetts,  70-1 

Prior  lien. 

Bonds,  199 

Ranking  order  of  lien,  186,  198 

Private  corporations. 

Classification,  6,  7 
Definition,  6 

Qualified  in  comparison  with  "public  service,"  14 
Regulation,  extent  of,  compared,  267 

Private  interest      (See  "Personal  interest") 
Proceeds  of  capitalization, 

Assurance  of  proper  use  important,  178,  267,  274 

Certification  on  bonds  purporting  to  assure  propriety  of,  175-6 

Commission  to  direct  use  of,  27,  178,  286 

Regulation  of  capitalization  most  effective  in  this  respect,  274,  427 
Place  of  expenditure  as  affecting  state  jurisdiction  (See  "Regulation  of  stock  and 

bond  issues:  jurisdiction  of  commissions") 

Profit,     (See  also  "Corporate  surplus  or  deficit") 

Applicable  to  payment  of  dividends,  how  determined,  123 

Definition,  English  courts,  124-6 

Definition,   United  States  courts,  123-4 
Current,  divisibility  of  in  face  of  impaired  capital,  123-7 
Part  of  corporate  assets  until  dividend  declared,  32,   128-9 


INDEX 


493 


Promoters'  fees, 

Capital  charge  as  part  of  organization  expenses,  366 
Abuses  of  capitalization  through,  364 
Legitimate  use  of,  364-5 
Proper  amount,  363 

Benefit  to  community  a  consideration,  366 

Examination  by  commission,  366 

Should  be  sufficient  to  encourage  pioneering,  365-7 

Property, 

Classification  into  real  and  personal,  165  (See  also  "Personal  property"  and  "Real 

property") 
Lien  upon  for  security  of  debt,  154  (See  also  "Mortgage"  and  "Security  for  funded 

debt") 
Nature  of,  effect  on  term  of  bonds,  193,  231,  245,  250 
Of  public  service  corporations,  value  of,  separate  from  operations,  168-9 

Property  dividends,  145-6 

Proportion  between  stocks  and  bonds, 

Authority  of  commission  to  prescribe,  considered,  259-60 
Bonds,  undue  proportion  of  in  early  finance,  251-2 

Conditions  producing,  254 

Evil  results  of  having,  252-4 

Railroad  stocks  alleged  to  represent  "water"  because  of,  252 
Consideration  controlling,  general,  260 
Difficulties,  general,  251 
Principles  governing  proper,  262 

Earnings  affecting,  261,  262,  263-5 

Corporate  control  affecting,  262-3 

Marketability  affecting,  265 
Railroad  capitalization,  present  proportion,  252 
Regulation  of,  by   statute,  292-4 

Restriction   withdrawn  as  to  public  service  corporations — California,  260-1 
Substantial  stockholders"  investment  to   support  loans,  252-4,  255,  259 
Tendency  to  increase  proportion  of  stock,  254 

Proprietary  corporation. 

Definition,  395 

Financing  of,  399,  405  (See  also  "Controlling  corporation") 

Proxy,  right  to  vote  by. 

Abuses  of,  85-6,  87 

Indifference  of  stockholders  responsible  for,  87,  90 
Definition,  87 
Illegal  exercise  of,  85 
Nature  of,  87 

Permission  of  law  required  in  charter  or  statute,  87 
Sale  of,  prohibited,  85 

Public, 

Corporations,  definition,  6 

Municipal  corporations,  7 
Duty  of,  toward  public  service  corporations,  21-2 

Attempts  to  perform  through  regulation,  23  (See  also  "Regulation") 
Faith  and  credit,  responsibility  of  commissions,  332 
Interest,   charging  private   enterprises  with,   14-5,   18-20,  22 

Protection   of,   by    commissions,   332-4,   402-3 
Policy,  affecting  authorizations  of  commission,  3324 
Records,  reports  filed  with  commissions,  27 
Regulation,  (See  "Regulation") 


494  ^^^^^ 

Publicity, 

Aid  in  controlling  capitalization,  269,  274.  275 
Necessity  for, 

To  protect  creditors,  64 

To  protect  investors,  64-5 

To  protect  stockholders,  78 

To  prevent  stock-watering,  61 

Public  service  commissions, 

Authority  to  regulate,  26-8 

Accounts  and  accounting  (See  "Accounting,"  and  "Accounts") 

Capitalization  (See  "Capitalization,"  "Regulation  of  stock  and  bond  issues") 

Competition  (See  "Competition") 

Intercorporate  relationships  (See  "Intercorporate  relationships") 

Operations,  27,  274,  323 

Organization  (See  "New  public  service  enterprises") 

Rates  (See  "Rates") 

Reorganization  (See  "Reorganization") 
Corporations  under  jurisdiction  of,  17-8,  2S-6,  276 

Status  of   foreign   and   interstate  commerce  corporations,  282-3 
Creation  of,  25,  274 

Organization  in  two  districts.  New  York,  26  (note) 
Paramount  duty  of,  304-7 
Powers  of,  enumerated,  26-8 
Regulation  by,  purpose  of  providing  for,  23,  25,  274,  288-9  (See  also  "Regulation") 

To  be  positive,  constructive,  and  permissive,  301 
Scope  of  authority  granted  to,  288 
Task  of,  generally,  28,  286 

Co-operative  effort  with  corporations  required,  288-9 

Public  service  corporations,    (See  also  "Public  service  undertakings") 

Accounts  of  (See  "Accounts,"  and  "Accounting") 

Capitalization  of  (See  "Capitalization,"  and  "Regulation  of  stock  and  bond  issues") 
Characteristics  of,  15,  17 
Classes  of,  19 
Common  carriers  as,  17 

Competition  between,  regulated  (See  "Competition") 
Definition,  14  (See  also  "Public  service  undertakings") 

Intercorporate  relationships  between,  regulated  (See  "Intercorporate  relationships") 
Operation  of,  commission  to  authorize  new,  27,  312  (See  also  "New  public  service 
enterprises") 
Continuance  of,  to  be  assured,  19,  20,  157,  170 

Affecting  corporation's  power  to  mortgage  properties,  157 
Security  for  debt  affected  by,  170,  183 
Control  of,  as  aid  in  regulating  capitalization,  269,  270,  274 

In  relation  to  rate  regulation,  323 
Paramount  duty  of  commission  to  maintain  continuance  of,  289,  304-5 
Regulated  by  commission,  27,  274 
Popular  to  attack,  331 

Private  corporations,  distinguished  from,  14 
Rates  (See  "Rates") 
Regulation  of,  basis  for,  19 
Relation  to  public,  20-1 
Assumed, 

Agency,  21,  22 
Partnership,  21-2 
Trusteeship,  21,  23 
Reciprocal  duties,  22 


INDEX  495 

Public  service  undertakings,    (See  also  "Public  service  corporations") 

Element  of  pubic  interest  controlling,  14   (See  "Public  interest") 

Enumeration  of,  17 

Natural  monopoly,  characteristic,  19-20,  25 

Private  undertakings  distinguished  from,  14 

Special  duties  of  those  engaging  in,  IS,  20 

Case  of  common  carriers,  15-6 

Development  of  laws  governing,  14-5 

Discrimination  in  rates  or  service  prohibited,  13 
What  constitute,  14,  20 

Common  carriage,  test,  15-6 

Declaration  of  California  Constitution,  18 

Governmental  function,  test,  17-8,  21 

Relation  to  needs  of  community,  18-9 

Purchased-line  bonds,  186,  188 
Purchase  money  mortgage  bonds,  202 
Purchase  of  plant, 

Accounting  upon,   391-2 

Commission's  supervision  over  transfers,  390 
Contract  for,  review  by  commission,  391 
Cost  of,  capitalization  for,  .190 


Railroad  commissions     (See  "Public  service  commissions") 
Railroads, 

As  common  carriers  and  public  service  undertakings,   17 
Public  highways,  21 
Regulation  of,  23-5 

Absence  of,  disastrous,  24 

Necessity  for,  25 
Stock  of,  held  by  other  railroad  corporations,  397 

Rates, 

Adequate,  duty  of  public  to  assure,  22,  73,  323 
Basis  of,  confusion  in,  64,  268 
Capitalization  and,  268,  320-3 

If  commission  controls  both,  320-1 

Statement  of  Massachusetts  commission,  321-3 
Competitive  railroad,  268 
Early  regulation  by  charter  provisions,  23 
Experimental  nature  of,  73,  307 
Reasonable,  what  constitute,  319-20,  326 
Regulation  of,  by  commission,  27,  319 

Demand  for,  because  of  monopolistic  enterprise,  319 

Relation  to  control  of  capitalization,  269,  270,  274 

Rate  wars. 

Causes  and  evil  effects  of,  24,  309  (See  "Competition") 

Regulation    designed    to    prevent    (See    "Certificate    of    public    convenience    and 
necessity") 

Reacquired  bonds. 

Status  of,  247.  249 


496  INDEX 

Reacquired  stock. 

Acquisition  of,  how  effected,  95 

Dormant,  not  sharing  in  dividends  or  control,  95 

Real  estate,    (See  also  "Real  property") 

Bonds,  defined,  187 
Mortgage,  165,  187 

Bonds,  defined,  187 
Power  of  corporation  to  buy,  hold,  and  sell,  11-2 

Real  property, 

Bonds  secured  by  mortgage  on,  185 

Classification  of,  18S-6,  187-8 
Mortgage  on,  155,  165  (See  also  "Mortgage") 
What  constitutes,  165 

Receiver's  certificates. 

Issue  of,  205 

Prior  lien  bonds  after  reorganization,  199 

Security  for,  205 

Redeemable  bonds. 

Definition,  186,  233 
Disadvantages  to  holders,  234 

Premium  paid  to  compensate  for,  234 

Redeemable  preferred  stock, 

Callable  same  as,  108 
Computation  of  yield,  221 
Definition,  100,  108 
Premium  paid  on,  108 

Redemption  of  bonds, 

Prior  to  maturity  (See  also  "Payment:  bonds  matured") 
Methods,  classification  of  bonds  according  to,  186,  233-4 
Process  of  amortization  (See  "Amortization  of:  funded  debt") 
Reasons  for,  233 

Refunding  first  mortgage,  201 
Refunding  mortgage. 

Bonds,  201 
First,  201 
First  and,  201 
Order  of  lien,  186 

Refunding  operations. 

Capitalization  incident  to,  authority  for,  286,  442,  450 

Conditions  producing  necessity  of,  450-1 

Cost  of  discharging  or  refunding,  451,  452-3 

Definition,  449 

Distinguished  from  funding  operations,  442-3 

Presumption  of  proper  original  issue,  451 

Registered  bonds, 

Definition,   162 
Denomination  of,  154,  162 
Indorsement  in  blank,  effect,  162 
Interchangeable  with  coupon  bonds,  162 
Interest  paid  to  owner  direct,  162 
Preference  for,  because  of,  164 


INDEX  497 

Registered  bonds — Continued 

Owner's  name  recorded,  162 

Payee,  description  of,  161,  162 

Principal  and  interest  registered,  162 

Principal  only  registered,  when,  163  (See  "Registered  coupon  bonds") 

Safety  in  keeping,  preference  because  of,   164 

Transfer,  writing  required,  163 

Difficulty  of,  a  disadvantage,  164 

Registered  coupon  bonds, 

Form  of  a  coupon  bond,  163 
Indorsement  to  bearer,  163 
Interest  collected  by  coupon,  163 
Principal  only  registered,  163 

Registered  stock,  45-6 
Registrar, 

Countersignature  on  stock  certificates,  45 

Regulation, 

By  commissions,  based  on  control  of  enterprises  charged  with  public  interest,  19 

Development  of,  23-5 

Purpose  of,  23 

Reciprocal  duties  of  public  recognized  in,  22,  23 

Requirements  of  public  policy,  330 

To  be  positive,  constructive,  and  permissive,  301 
Charter  provisions  intended  to  secure,  23 
Development,  early  exercise  over  common  carriers,  23-5 

Extension  of  (See  "Public  service  commissions") 
Introduced  to  correct  evils   of  unrestrained   competition,  24   (See  also  "Competi- 
tion") 

Regulation  of  stock  and  bond  issues  by  state  commissions. 

Authorization  of  commission  required,  27,  274,  289 

Great  latitude  allowed  to  commissions,  274,  290-1,  294 
Limitations  on  discretionary  power  if  statute  is  complied  with,  287,  292-4 
Capital  to  be  secured  by  issue,  290 
Collateral  aspects  of  capitalization  to  be  considered,  308 

So  also  incidents  of  capitalization,  290-2 
Considerations  of  public  policy,  330,  332 
Co-operative  effect  of  commission  necessary,  288 
Demand  for,  267-  8 
Direct  powers  of  commission,  268 
Effectiveness  of,  274,  275 

Examination  to  be  made  by  commission,  what  to  include,  291-2 
Indirect  powers  of  commission,  274-5 

Jurisdiction  of  commissions  in  respect  of,  generally,  275,  283-4 
Domestic  corporations,  276 

Effect  if  proceeds  are  to  be  spent  outside  state,  276-81 

Maryland,  decision  of  court,  277-8,  279,  281 
Nature  of  securities,  affecting  jurisdiction,  279-80 
Foreign  corporations,  281-5 

Effect  if  proceeds  are  to  be  used  within  state,  281,  285 
Nature  of  securities,  affecting  jurisdiction,  283-5 
Price  of  issue  to  be  fixed,  218-9 

Public  confidence  in,   effect  on   securities  market,   254-5 
Purpose   of  providing  for,   289,  427,  44S 


498 


INDEX 


Regulation  of  stock  and  bond  issues  by  state  commissions — Continued 

Purposes  for  which  authorization  may  be  had,  286-8  (See  detail  under  "Capitaliza- 
tion") 

Regulation   to   be  constructive,  301 

Requisites  for  authorization,  290 

Probability  of  adequate  return  upon,  292,  337-8 
Reasonableness  of  amount,  286,  289,  291 

Responsibility  of  commission,  325,  330 

Right  of  public  to  rely  on  findings,  326-7 

State  not  a  guarantor   of  authorized   issues,  322,  325-6 

Uniformity    in    laws    and    practices    required,    275 

Conflicts  limit  efificiency  of  state  regulation,  270-1,  281 

Reimbursement  of  income  or  surplus, 

Capitalization  for,  of  moneys  expended  on  fixed  capital. 

Amount  of  moneys  expended,  accounts  to  disclose,  429-33 

Depreciation  accrued  to  be  deducted,  432 

Investment  of  special  funds  to  be  excluded,  430 

Matters  includible  in,  438 

Valuation  or  appraisal,  if  records  cannot  disclose,  433,  436 
Reproduction  cost  not  applicable,  436 
Application  for  authority  to  be  made  within  period  limited,  427,  428 
Authority  for  capitalization,  286,  426-7 

Basis  of  right,  427 
Expenditure  for  proper  purposes  to  be  shown,  431 

Maintenance  and  replacements  not  proper  purposes,  430-1 
Right  of  corporation  for  authorization  if  statute  is  satisfied,  437-8 
Stockholders'  interest,  how  affected  through  reimbursement,  428-9 

Reinforced  security, 

Guarantee  by  third  party,  206 

Careful  examination  necessary  to  determine  security,  206 
Indication  by  indorsement  on  bonds,  206 
No  lien  on  property  of  guarantor,  206 

Remedies  of  bondholders, 

Enforcement  of,  on  default,  180 

Postponement  of  effective  date,  180-1 
Through  trustee,  159,  181 

Bondholders  may  direct  action  of  trustee,  181 
On  default  of  trustee  bondholders  may  act,  174,  181 
Foreclosure  (See  "Foreclosure") 

Possession  of  property  assumed  under  power  of  mortgage,  181 
Restriction  placed  on,  by  public  policy,  168,  170,  183 
Sale  of  property  under  power  of  mortgage,  181 

Reorganization, 

Capitalization  increased,  usual  incident  of,  255,  422 
Compromise  usually  representing  a,  184 

Favored  by  law  to  avoid  foreclosure,  183 
Different  meanings  of  term,  422-3 
Fixed  charges,  purposes  to  reduce,  423 
Jurisdiction  of  commission,  28,  423-4 
Method  following  foreclosure,  183,  423 
Organization  of  new  company,  183-4 
Plan  prearranged,  423 
\'alue  of  property,  to  control  capitalization,  424 

Difficult  to  determine,  425 

New  York  court  decisions  relating  to,  424-5 
Statute  amending  rule,  423-4 


INDEX  499 

Replacements, 

Definition,  355-6 

Expenditures  for,  accounting  of,  356-7 
Proper  accounting  important,  118 

Capitalization  abused  by  improper  accounting,  303-4 
Repairs  and  maintenance  distinguished,  355 

Reports, 

Of  corporations  to  public  service  commissions,  27 

Public  records,  27 
Publication  of,  effect  on  regulation  of  capitalization,  269 

Reproduction  cost. 

Application  to  public  service  properties  limited,  338-9 

Attempted  use  as  basis  of  fixed  capital  accounting,  337-8 

Use  in  determining  sum  of  capital  expenditures  from  income,  436 

Right  of  way, 

Value  of,  apart  from  operation,  168-9 

s 

Sale, 

Of  plants  devoted  to  public;  authority  required  for,  26,  390 
"Anti-trust"  laws  and  general  public  policy  to  control  authorization,  322 

Scrip, 

Convertible,  definition,  134 

Definition,  133 

Dividends    paid    in,    133-4 

Participation  in  dividends,  134 

Possible  use  to  evade  statutory  dividend  prohibitions,  135 

Second  mortgage  bonds,  199 
"Secret  reserve," 

Created    by   charging   capital    expenditures   to   operating   expenses,    336   (See   also 
"Income:  appropriations  from,  for  investment  in  fixed  capital") 

Secured  funded  debt. 

Classification  of,  by  nature  of  property,  185-6 
Credit,  bonds  resting  upon,  not  constituting,  154 
Definition,  154,  185 

Security  for  funded  debt. 

Classification  of  bonds  on  basis  of,  185,  187 

Control,  share  in,  given  to  bondholders  to  increase,  170-1  (See  also  "Bondholders: 

control  over  acts  of  corporation") 
Earnings,  ability  to  maintain,  constituting  essence  of,  170 
Equal  rights  of  bondholders  in  respect  of,  158-9 
Increase  in,  eflfected  by  serial  maturity  or  sinking  fund,  243  (See  also  "Equipment 

obligations,"  "Serial  maturity,"  and  "Sinking  fund") 
Intangible,  consisting  of  debtor's  credit,  154 
Interest  rate  aflfected  by,  211,  216 

Investors'    desire   for,    facilitating   corporate  borrowing,   147,    154 
Lien,  creation  for  purposes  of,  155 

Maintenance  of  property  constituting,  provisions  for,   171-2 
Mortgage,  careful  examination  of  provisions  necessary  to  estimate,  171 
Principal  and  interest  equally  protected,   159-60 

Interest  alone  secured  by  pledge  of  income,  166  (See  also  "Income  bonds") 


500  INDEX 

Security  for  funded  debt — Continued 

Reinforced,  187,  206  (See  also  "Guaranteed  bonds"  and  "Sinking  fund") 
Resort  to,  in  case  of  default  (See  "Remedies  of  bondholders") 
Value  of,  and  amount  of  debt,  167 

What  constitutes,   in  public  service  plants,  168-70  (See  also  "Value  of  public 
service  plants") 
What  constitutes,  154,  171,  250 

Senior  bonds,  199 

Serial  bonds,  186,  239     (See  also  "Serial  maturity") 

Serial  maturity. 

Amortization  of  debt,  method,  237,  245 

Bond  values  affected  by  variations  in  terms  of  bonds,  239 

Equipment  obligations  subject  to,  193,  243 

Equity  of  bondholder  increased  by,  193,  243-4 

Instalments  equal  in  amount  of  maturing  principal,  245 

Equal   instalment,  viz.,  principal  plus  interest,  246 

Failure  to  pay  any,  matures  entire  series,  245 
Reflecting  nature  of  property  by  which  secured  or  for  which  used,  193,  245 
Relation  to  accruing  depreciation,  193,  243-4 
Sinking  fund  compared  with,  in  respect  of  amortization,  243,  245 

Share  capital,  148 

Shares  of  capital  stock  (See  also  "Stock"  and  "Subscriptions") 
As  "goods,  wares,  and  merchandise"  within  Statute  of  Frauds,  40 
As  personal  property,  47 

Purposes  of  taxation,  51 
Definition,  32 

Limitations  upon  number  to  be  individually  owned,  35 
Meaning  of  "shares"  in  usage  of  England,  111,  204 
Par  value  of  (See  "Par  value,"  and  "Shares  without  par  value") 
Representation  of,  34 
"Shareholders"  (See  "Stockholders") 
Taxation  of,  51-53 

Transferability  of  (See  "Transfer") 
Value  of,  for  purposes  of  taxation,  52 

Shares  without  par  value. 

Accounting  record  of  price  realized  on  issue,  82 

Collateral  requisites  for  successful  use,  83 

Experimental  stage,  adoption  of  method  in,  83 

Fractional  interest  in  corporation  representing,  78 

New  York  statute  in  respect  of,  80-1 

Par  value,  shares  having,  compared  with,  36,  81-3 

Preferred  stock,  when  not  applicable  to,  55,  80,  99 

Purpose  in  using,  78-9 

Remedy  for  evils  of  overcapitalization,  intended  to  be,  81 

Shares  of  joint-stock  associations,  compared,  81,  82 

Short-term  bonds  (See  "Notes") 
Silver  bonds,  236 
Sinking  fund. 

Amortization  of  debt,  method  of,  237 

Equalizing  burden  of,  246 

Serial  maturity  as  another  method  of,  compared,  245 
Appropriations  to,  source  of,  241-2 


INDEX 


501 


Sinking  fund — Continued 

Definition,  239-40 

Desirability  of,  for  supposed  bondholders'  assurance,  243,  249-50 

Equity  of  bondholders  increased  by,  243 

Increments  of,  disposition  made  thereof,  240 

Operation  of,  and  accounting  for,  240-2 

Reinforcing  security  of  debt  by,  187,  206 

Of  limited  utility,  249-50 
Relation  to  depreciation,  243-4 

Sinking  fund  bonds,  187,  206 
Sinking  fund  investments. 

Cash  funds,  246 

Company's  plant,  248-9 

Company's  securities,  246-7 

Control  over,  249 

Earnings  of,  disposition,  240 

Securities  of  other  companies,  247-8 

Trustee,  relation  to,  249 

Solvency  of  corporation, 

Balance  sheet  measuring,  118,  342 

Facts  concerning,  hidden  by  defective  accounting,  116 

Special  act,  incorporation  under. 

Abuses  introduced  into  method,  10 
Advantages  which  accrued  from,  23,  309 
History  of,  9-11 

Prohibition  against.  New  York  constitution,  10-11 
Recitals  of  statute,  10 

Special  franchises. 

Accounting  for  costs  of  acquisition,  392-3 

Annual  costs  imposed  by,  not  subject  to  capitalization,  370-1 

As  property,  367,  368 

Cost  of, 

Chargeable  to  capital,  368 

Subject  to  capitalization,  369,  371 
Definition,  367 

Exercise  of  powers  under,  to  be  authorized  by  commission,  26 
Free  service  given  under  terms  of. 

Accounting  for  costs  of,  373 

Constituting  discrimination,  369 
General  franchise,  distinguished  from,  367-8 
Lease,   transfer   or   other   agreement   concerning   ownership   to    be   authorized   by 

commission,  26,  371 
Mortgage  of  corporate  realty  including,  165-6 
Purchase  or  assignment,  371-2 
Sale  of  by  municipality,  method  criticized,  369 
Value  for  capitalization  purposes  not  to  exceed  cost,  369 

Special  privilege, 

Right  to  issue  stock,  bonds,  etc.,  declared  to  be  a,  283 

Comment,  283-4 

"Special  franchise,"  compared  as  to  meaning,  284 

Special  stock,  110 

Specific  powers  of  corporation,  11 


502 


INDEX 


State, 

Incorporation  of  private  companies  (See  "General  laws,"  and  Special  act") 
Jurisdiction  over  domestic  corporation,  276,  284 

Capitalization  of  (See  "Capitalization:  state  jurisdiction  of") 
Jurisdiction  over  foreign  corporations,  282 

Capitalization  of  (See  "Capitalization:  state  jurisdiction  of") 

Police  power,  basis  of,  278,  282 
Jurisdiction  over  interstate  commerce  corporations,  283 
Public  service  commissions  (See  "Public  service  commissions") 
Public  service  corporations,  regulation  of  (See  "Regulation") 
Real  property  within  its  borders,  right  to  control,  280,  285 

Statute  of  frauds, 

Agreements  for  purchase  of  shares,  39,  40 

Statutory  restraints  on  watering  stock. 

Aim  of  statutes,  61-2 

English  law,  63-4  (See  also  "England:  Prospectus  Act  of") 

French  law,  62 

German  law,  62-3 

Public  service  commission  laws,  65-6 

Stock  (See  also  "Capital  stock,"  "Shares,"  and  "Subscriptions") 

Bonds   and,   compared,    152 

Book,  40 

Closing  of,  prior  to  payment  of  dividends,  146 

Inspection  of,  by  stockholders  and  judgment  creditors,  40 

Certificates  (See  "Certificates  of  capital  stock") 

Corporation  investing  in  its  own  (See  "Acquisition:  of  stock  of  own  issue") 

Dividend  paid  in  (See  "Stock  dividend") 

Issue  of,  what  constitutes,  38-40 

Market  for,  compared  with  bond  market,  254 

Effect  on  determining  proportion  of  bonds  to  stock,  265 

New,  offered  to  stockholders,  263 

Ownership  of,  for  purposes  of  control  (See  "Controlling  coTporation") 

Right  to  issue,  declared  to  be  a  "special  privilege,"  284 

Sale  of,  commissions  paid  on,  71 

"Shares"  distinguished  from,  in  usage  of  England,  111,  204 

Subscriptions  to  shares  of  (See  "Subscriptions") 

Stock  corporations. 

Advantages  of  organizing  into,  7-8,  31-2 

Incidents  of  ownership  allocated,  12-3 

Partnership,  compared  with,  12  (See  also  "Stockholders:  limited  liability") 
Civil  corporations  as,  6,  7 
Definition,  7-8 

Finances  of  (See  "Corporation  finance") 
Interest  of  members  in  capital,  control,  and  profits,  8,  31 

Agreements  to  classify  stock  modifying,  96 

Par  value  of  shares  adopted  for  ease  in  division  of,  32 
Private  corporations,  classification  of  including,  6-7 
Purpose  in  organizing,  7,  31 

Objects  to  be  in  accord  with  public  policy,  9 
Stockholders'  relation  to,  7,  8,  31 

Stock  dividend. 

Authorization  for,  where  found,  139-40 

Definition,  138 

Distribution  of,  effect  on  stockholders'  interest,  138-9 


503 


INDEX 

Stock  dividend — Continued 

New  York  Central  distribution  of  "interest  certificates,"  141-S 
Purpose  of,  to  divide  profits  invested  in  capital,  138 
Statutory  restrictions  on  declaration  of,  139 

Indirect  method,  140-1 
"Watering  stock,"  alleged  means  of,  58 

Stockholders, 

Acting  for  corporation;  appointment  as  officer  or  employee  necessary,  7 

Bondholders  distinguished  from,  210-1 

Control  over  corporation,  inherent  right  to  share  in,  84,  104,  171,  394 

Apportionment    of,    between    classes    of    stockholders,   84,    96,    104 
Divergent  interest  introduced,  105 
Proportionate  amount  of  shares  in  each  class  affecting,  96,  106 

Direct,  what  constitutes,  85 

Exercised  by  majority,  394  (See  "Majority  control") 

Indirect,  over  management  and  property  of  corporation,  84-5 

Limitations  upon,  in  favor  of  bondholders,  84 

Preference  in,  given  to  one  class  of  stock,  104 
As  sole  basis  for  classifying  stock,  98 

Classification   of   preferences,    105-6   (See   also    "Control,"   and   "Preferred 
stock:  voting  rights") 

Specific  limitations  by  agreement,  395 
Creditors  distinguished  from,  99-100 
Interest  in  control,  capital,  and  profits  of  corporation,  8,  31 

Agreements  to  classify  stock  modifying,  96 

Title  to  assets  is  equitable,  not  legal,  130 

Undivided  interest  in  assets  of  corporation,  31,  129 
Limited  liability  of,  8,  12,  31,  56 
Meetings  of,  basis  of  representation  at,  90 

Proportion  of  voting  rights  required  to  authorize,  90 
Number  of,  may  be  limited  by  restricting  ownership  of  shares,  35 
Of  record,  definition,  46 

Rights  of.  46-7,  146 
Proprietors  of  corporate  enterprise.  2.  31,  33-4,  36.  210 

Must  have  contributed  to  capital  of  corporation.  40 
Proprietorship,  value  of,  54,  72,  76 

DiflScuIty  of  ascertaining  from  accounts,  11 
Proprietary  interest  indicated  by  shares  holdings,  12,  35 

Affected  by  class  of  stock  held,  96 
Public  service  corporations  as,  87,  94-5,  396 
Qualifications  of,  generally,  94 

Restrictions  on  public  service  corporations,  27,  94-5,  396 

Stock  corporations  as,  94 
Relationship  of,  32.  36-7,  38,  43 
Title  to  and  remedies  for  undivided  profits,  128-131 

For  dividends  declared  and  due,  130 
Traders  on  the  equity  as  (See  "Trading  on  the  equity") 

Straight  bonds,  186,  239 
Subscriptions  to  shares  of  stock, 

Agreement  for,  43 

After  incorporation,  45 

Before  incorporation,  44-5 

Of  subscribers  to  certificate  of  incorporations,  44 
Forfeiture  of  stock  for  nonpayment  of,  43 


504 


INDEX 


Subscriptions  to  shares  of  stock — Continued 

Liability  for  payments  on  call  of  directors,  distinguished  from  debt  of  promissory 

note,  43-4 
Receipt  for  payments,  effect  of,  38 
Remedy  of  corporation  for  failure  to  pay,  43,  44 

Subsidiary  companies   (See  "Controlling  corporations") 
Surplus, 

Appropriations   from,   for   investment   in   capital,    129   (See   also  "Income:   appro- 
priations") 

Accounting  for,  123,  129 

Capitalization  of,  426  (See  "Reimbursement") 
"Book"  and  real,  distinguished,  118-120,  123 

Definition,  115,  118  (See  also  "Corporate  surplus  or  deficit  account") 
Dividends  must  be  paid  out  of,  113 

Amount  applicable,  how  determined,  115,  123  (See  also  "Profit") 

Unwise  to  apportion  entire  amount,  127 
Importance  of  accounting  in  determination  of,  116,  119 
Investments  in  securities  of  other  companies  or  in  outside  properties  to  be  made 

out  of,  414 
Manipulation  of,  121-2 

System  Corporations, 

Affiliated  corporations  as,  395  (See  also  "Intercorporate  relationships") 
Financial  transactions  between,  to  appear  distinctly  on  balance  sheet,  121  (See  also 
"Controlling  corporations") 

T 

Tangible  capital. 

Capitalization  for  acquisition  of,  379  (See  also  "Construction,"  and  "Purchase  of 

plant") 
Definition,  358 

Taxation  of, 

Bonds,  as  personal  property,  206 

Exemption  of  governmental  and  municipal  bonds,  208 

Levy  upon  income,  208 

Tax-free  covenants,  construction  of,  160,  208-9 

Levy  upon  principal,  207 

Unfair  to  tax  both  principal  and  income,  208 

State  policy  in  relation  to,  differences  in,  207 
Corporate  properties  and  enterprises,  51 
Shares  and  capital  stock,  51 

Authorized  capital  stock,  tax  levied  upon  organization,  S3 

Capital  stock,  tax  levied  against  corporation,  51-2 

Double  taxation,  danger  of,  52 

Shares  as  personal  property,  51-3 

State  policy  in  relation  to,  differences  in,  52 

Temporary  bonds,  160 
Temporary  stock  receipts,  38 
Terminal  bonds,  186,  188 
Term  of  bonds, 

Classification  on  basis  of,  186 

Determined   by  nature  of  security,   193,  231,  245,   250 


INDEX 


505 


Term  of  bonds — Continued 

Effect  on  value  of  bonds,  230 

Factor  in  computation  of  investment  yield,  221 

Market  conditions  at  time  of  issue  controlling,  231,  232 

Texas, 

Experience  of,  in  limiting  capitalization  to  reasonable  value  of  property,  69,  302 

"Trading  on  the  equity," 

Advantage  to  stockholders,   147,  237 

Consideration  inducing  stockholders  to  give  up,  255 
Definition,  147 

Traffic, 

Failure  of,   effect  on  value  of  a  railroad,   169 
Transfer, 

Agent,  appointment  of,  45 

Countersignature,  when  required,  45 
Duties,  of  46 
Bonds, 

Payable  to  bearer,  by  delivery,  163 
Registered,  writing  required,   162 

Exception  of  registered  coupon  bonds  indorsed  to  bearer,  163 
Shares  of  capital  stock, 

Assignment  in  writing  required,  46 
Form  printed  on  certificate,  37,  46 
Indorsement  in  blank,  effect  of,  46,  SO 
Record  on  books,  46,  47,  146 
Ledger  for  48 

Prohibition  affecting  public  service  corporations,  27,   47-8 
Transferee  entitled  to  demand,  47 
Right  of  transfer. 

Reasonable   restrictions  proper,  47 

Suspension  of,  in  French  law,  applying  to  vendor's  shares,  62 
Tax,  48 

Trust  deed, 

Authority  for  execution  of,  158 

Bond  agreement,  incorporated  in,  159,  162 

Bondholders,  beneficiaries  of,  158 

Bonds,  amount  of  issue  provided  for  in,  160 

Bonds,  form  of  described  in,  162 

Circumstances  necessitating  use  of,  156-7 

Form  of,  157 

Parties  to  execution  of,  158 

Trustee   (See  "Trustee") 

Trustee, 

Acts  of,   binding  on  bondholders,  174 

Appointment  of,  under  corporate  deed  of  trust,  173 

Bondholders'  rights  and  remedies  exercised  through,  174 

Care  of  collateral  pledged,   174,   179-80 

Certificate  of,  indorsed  on  bonds,  161   (See  also  "Certification") 

Duties  of,  173,  175 

Duty   to   proceed  against   property,   when  obligatory,   159 

Failure  to  act,  bondholders  may  act,  174 

Injunction  to  restrain  acts  of,  when  available,  173 

Legal  title  conveyed  to,  in  trust  for  bondholders,  156,  158 


5o6 


INDEX 


Trustee — Continued 

Liability  of,  limited,  173,  174,  177 

Majority  stockholders  as,  to  minority,  91 

Public  service   corporation  considered  as,    21 

Relation  to  bondholders,  173 

Relation  to  corporation,  174,  249 

Removal  of,  173 

To  examine  security,   174-5 

Trust  companies  as,  173-174 

Trust  fund  theory,  55-6 

u 

Unamortized  debt  discount  and  expense. 

Text  of  account,  223-4 

Underlying  bonds,  199 

Unextinguished  discount  on  capital  stock, 

Text  of  account,  75-6 

Unextinguished  premium  on  outstanding  funded  debt. 

Text   of  account,   225-6 

Unfunded  debt. 

Definition,  149 

Financing   by    (See   "Notes") 

Uniform  stock  transfer  act, 

Warranties  of  transferor   of   stock   described,   50-1 

Uniform  systems  of  accounts. 

Authority  of  commission  to  prescribe,  27 
Purpose  of  requiring,   116 

Unifying  mortgage  bonds,  201 
Unsecured  funded  debt. 

Classification   of,  202-3 

Contingent  security,  203 

Credit,  debts  resting  upon  constitute,  154 

Definition,  202 

Desirability  of,  not  measured  by  lack  of  tangible  security,  154 

Limited  market  for,  155 

Receivers'  certificates  as,  205 

Usury  laws 

Not  operative  on  corporations,  214 

V 

Valuations, 

Basis  of  accounting,  341-2,  435 

For   purposes   of    estimating   overcapitalization,   302 

Misapprehension  concerning  nature  of,  433 

Physical,  of  railroad  property,  252,  270,  414,  433-S 

Qualifications  with  which  results  must  be  stated,  434,  435 

"Reproduction  cost"  basis,  339,  435 

Restatement  of  accounts  on  basis  of,  342,  344,  435 

Revisions  of  accounts  on  basis  of,  342-3,  435 


INDEX 


507 


Value  of  public  service  plants, 

Accounts,    difficulty   of   including,    119,    337-9,    343,   435    (See   also    "Fixed   capital: 

accounting  for") 

Manipulation  responsible  for  abuses  of  capitalization,  337 
Definition,  absence  of  agreement  as  to  a  satisfactory,  433-34 
Earning  power  as  basis  of,  337-8 
Original  cost  as  basis  of,  337 
Realized  on   sale  at  foreclosure,   183 
Real,  not  obtainable,   119,  168 

Open  markets,  absence  of,  168-70 

Operation  and  use  necessary  to  give,  169-70 
Reproduction  cost  as  basis  of,  339 
Sale,  restrictions  on,  affecting,  168 
Success  of  enterprise  controlling,  169-70 
Test  of,  339,  434 

Voting  rights, 

Alienation  from  ownership  of  capital  stock  forbidden,  85 

Harmful   results  of   permitting,  85-6 

Statutory  misdemeanor,  85 

Voting  trust,  exception  in  case  of  (See  "Voting  trust") 
Bribe,  exercise  of,  under,  86-7 
Classification  solely  as  to,  unusual,  104 

Instance  of  common  stock  so  classified,  98 
Exercised  in  corporate  welfare,  86-7 
Sale  of,  not  permitted,  85-6 

Voting  trust. 

Agreement  of,  provision  in  statute,  88 

Certificate  of,   issued  to  participants  in,  88 

Dividends   on  stock  held   in,  88 

Distinguished  from  deposit  of  stock  with  proxy,  89 

Term  limited,  88 

Purpose  of  obtaining  concerted  action,  88 

Object  must  be  legal,  88 
Trustees  under,  88 

w 

Watered  stock, 

Aspects  of  sometimes  considered  defensible,  66-8  (See  also  "Discount:  stock  sold 

at") 
Definition,  58 

Financing  through  construction  companies  as  means  of,  387-8 
Forms  in  which  appearing,  58-9 
Issue  for  property,  labor,  and  services,  as  means  of,  59  (See  also  "Consideration 

realized  on  issue  of  securities") 
Publicity  of  facts  concerning  issue  of  stock  as  remedy,  61-2 

Basis  of  English  legislation,  63-4,  69 

Limitation  on  utility  of,  65 
Rates  and  service,  supposed  effects,  61,  64-5 
Regulation  by  commissions  as  effective  remedy,  65-6 

Supposed  inadequacy  of,  68-9 
Statutory  restraints  on. 

Aim    of,   61-2 

Devices  used  in  European  countries,  62-4 

Laxity  in  enforcement  of,  reason  for,  66 

Legislation  in  United  States,  66 


I 


508      .  INDEX 

Watered  stock — Continued 

Stock  of  railroad  corporations  alleged  to  represent,  252 
Suspending  negotiability  of  vendors'  shares,  France,  62 

Wharf  bonds,  188 
Working  capital. 

Capitalization  to  provide  for  beginning  operations,  392-3,  439 
For  maintenance  of  service,  when  allowed,  392,  438-40 


I 


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